Understanding Crypto Derivatives

Crypto derivatives are financial contracts whose value is based on the price of cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), Solana (SOL) or even meme coins like Dogecoin (DOGE). Instead of being pegged  to physical assets like gold, oil, or company shares, these derivatives are tied to digital assets that live on blockchains.

They still serve the same purpose as traditional derivatives: to speculate, hedge, or arbitrage. However, crypto comes with its own twist on the formula!

‍

While crypto derivatives operate on the same basic principle as their traditional finance counterparts, several key differences set them apart. 

First, crypto markets never sleep. They’re open 24/7, unlike traditional stock or commodity markets that close on weekends and holidays. This non-stop trading means opportunities (and risks) are always on. 

Second, many crypto derivative platforms are decentralized. That means you can trade directly from your crypto wallet without needing a broker, a bank, and often no ID required. This pseudonymous, permissionless system removes barriers and opens global participation to anyone with an internet connection. No middlemen needed!

Another big difference is leverage: crypto platforms often offer significantly higher leverage  than traditional finance (sometimes up to 100x) amplifying both potential gains and losses. 

Additionally, settlement is usually done in crypto or stablecoins instead of fiat, wherein trades are often settled instantly or within minutes. 

Finally, innovation in crypto happens quickly. New derivative products and experimental models appear constantly. Unlike the slower-moving, heavily regulated world of traditional finance, crypto derivatives operate in a dynamic, experimental environment.

‍

Let’s go into the main types of crypto derivatives. Each of these contracts plays a different role depending on your trading style, risk appetite, and market strategy.

‍

Crypto Futures Contracts

Crypto futures are agreements to buy or sell a specific cryptocurrency at a predetermined price on a future date. Much like their traditional counterparts, they allow traders to speculate on the direction of an asset’s price, whether it’s going up or down. They are also settled through official exchanges. 

Let’s say you think the price of ETH will rise next month. You could buy a futures contract today that locks in the price at $3,000. If ETH climbs to $3,500 when the contract expires, you profit from the $500 difference, without ever owning the asset.

Most crypto futures are cash-settled, meaning you don’t actually receive cryptocurrency. Instead, gains or losses are settled in cash or stablecoins. Physically-settled futures, where you receive the crypto itself, do exist but are less common. 

There are two types of crypto futures:

• Inverse Futures: These are margined and settled in the crypto itself. For example, you post Bitcoin (BTC) as collateral and your profits or losses are also calculated in BTC.
  
  
• Linear Futures (aka Vanilla Futures): These are margined in stablecoins like USDT (Tether) or USDC. This makes it easier for traders who prefer to think in dollar terms, even when trading crypto assets.
  
  

As with all derivatives, crypto margins require margin. If the market goes against your trade and your margin drops below a certain level, you risk liquidation.

‍

Crypto Perpetual Swaps

Perpetual swaps, often called perps, are like the adrenaline-fueled cousins of futures contracts. They function similarly but with one key difference: they have no expiration date. That’s right, no end date. In theory, you can hold a position indefinitely. In practice, most traders don’t, but this flexibility makes perpetuals especially popular among active traders.

To keep perpetual prices aligned with the real (spot) market price of the underlying crypto, a mechanism called a funding rate is used. This is a small fee exchanged between traders based on whether the perpetual contract is trading above or below the spot price: 

• If the perpetual price is above the spot price, long traders (those betting the price will go up) pay the funding rate to short traders. 
• If the perpetual price is below the spot price, short traders pay the fee to long traders.

Funding rates typically reset every 8 hours, allowing traders to manage their positions accordingly. 

Popular platforms offering perpetuals include centralized exchanges like MEXC, and decentralized exchanges like dYdX.

Crypto Options Contracts

Crypto options work just like options in traditional finance. They give you the right, but not the obligation, to buy or sell a crypto asset at a specific price (called the strike price) before a certain date (the expiration date). They have call options (right to buy) and put options (right to sell) as well. 

Crypto traders use options for a range of strategies like speculation, hedging, or generating passive income. For example, if you think BTC will go up, you might buy a call option with a strike price of $60,000. If BTC rises to $70,000, your option is “in the money,” and you can profit. Platforms like Deribit and Aevo specialize in crypto options, while centralized exchanges are starting to offer them too.

‍

Crypto derivatives offer a powerful toolkit for traders, investors, and institutions alike. Here’s what makes them so valuable:

• High Liquidity: Major crypto derivatives markets are deep and highly active, with billions traded daily on leading exchanges. This high liquidity means you can usually enter or exit a position quickly with minimal price slippage.
  
  
• Low Barriers to Entry: You don’t need to be a millionaire or a hedge fund to get started. Many platforms allow you to start trading with as little as $10, making it accessible to beginners or small-scale traders who want to test the waters.
  
  
• Speculate in Both Directions: Unlike buying crypto on the spot market, where you only earn when prices rise, derivatives allow you to profit from market moves in either direction. You can go long if you think the price will rise, or short if you anticipate a drop.
  
  
• Hedge Your Portfolio: If you’re holding a lot of crypto and fear a potential crash, you can open a short futures position to offset the loss. This is like buying insurance for your portfolio. If prices dip, your hedge can cushion the blow.
  
  
• Capital Efficiency: Leverage allows you to control larger positions with less capital. For example, with 10x leverage, you only need $100 to open a $1,000 position, though it also means your losses can grow just as fast.
  
  
• 24/7 Access: Crypto markets never sleep. Unlike traditional markets, crypto derivatives can be traded around the clock, even on a  Sunday night or a public holiday. This nonstop action offers more opportunities to make a gain.
  
  
• No Custody Hassles: Since you’re trading contracts rather than actual crypto assets, there’s no need to manage wallets, private keys, or sending tokens around. This streamlines the process and reduces the risk of loss or theft.

‍

Crypto derivatives are primarily traded on two types of platforms: centralized exchanges (CEXs) and decentralized exchanges (DEXs). Each has its own strengths, trade-offs, and ideal user base.

‍

Centralized Exchanges (CEXs)

CEXs are run by companies that serve as intermediaries, managing your trades, custody, and settlement. They offer a user-friendly experience, deep liquidity, and advanced trading tools. However, they require users to create accounts, complete KYC (Know Your Customer) verification, and trust the exchange to securely hold their funds. This reliance on a third party introduces counterparty risk and reduces user control. Some examples of CEXs would be MEXC, OKX, Bitget, Bybit, Binance, and Coinbase. 

‍

Decentralized Exchanges (DEXs)

DEXs take a completely different approach. Instead of relying on intermediaries, trades are executed on-chain via smart contracts, allowing users to retain full custody of their funds throughout the entire process. There’s no need for  accounts, identity verification, and third-party trust. This non-custodial model aligns closely with the values of decentralization and privacy. However, DEXs often come with a steeper learning curve, higher gas fees, and occasionally lower liquidity compared to centralized platforms. Some examples of DEXs include dYdX, GMX, Aevo, and Level Finance. 

The right choice between a CEX and a DEX depends on what a trader values more -  convenience and liquidity, or self-custody and decentralization. 

Learn more about DEXs here 

‍

Crypto derivatives give traditional financial tools a digital upgrade. They’re fast, powerful, and globally accessible. But with that power comes serious risk, which is exactly what we’ll cover next! If you don’t respect leverage, it won’t respect you back.