For the uninitiated, it is important to understand what derivatives are, why they are important, why there was a sudden surge in these markets and how one can use APEX:E3 to discover, analyse and eventually execute trading strategies in these markets.
What are derivatives?
A derivative is a contract between two or more parties. The contract derives its price from fluctuations in the price of its underlying asset.
Types of derivatives include:
Futures: This is a contract which consists of an agreement between two parties for the purchase and sale of an asset at an agreed future price. This is a standardised contract and therefore can be traded on exchanges. Both parties involved in the contract are obligated to buy or sell the underlying asset at the agreed date.
Swaps: In traditional financial markets, Swap contracts generally comprise of two cash flows being exchanged between two parties. For example, two parties may agree to swap interest payments, one being fixed and the other being a floating-rate. However, in the context of digital assets, ‘swaps’ generally refer to perpetual futures contracts i.e. a futures contract with no expiry date. These contracts are traded using the index price of the underlying asset. The index price is composed of the average price of the asset based on the main spot markets across different exchanges (to avoid price manipulation).
Options (Coming soon): An options contract is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. This is similar to a futures contract but has a key difference. With an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, whereas futures are obligations.
Forwards: These are similar to futures but are non-standardised contracts because they typically consist of customised terms around the settlement of the underlying asset. Due to their non-standard formulation they are not traded on exchanges and are instead traded over-the-counter (OTC) between counterparties.
Why are Derivatives Important?
Derivative contracts are typically used to hedge against risk or speculate on the price of the underlying asset.
Derivatives can also help manage directional risk in volatile markets. Earlier this year the price of Bitcoin dropped over 40% and then recovered over 15%. Bitmex saw over $600 million of liquidations during this period. These events represent significant amounts of volatility, increasing directional risk for traders. If a trader’s position does not have enough margin they face accelerated risk of liquidation.
Traders can use futures to position themselves for directional risk.
Futures contracts have existed for hundreds of years in various forms, even dating back to Ancient Greece. However, in the form we are most familiar with now, futures contracts first became prevalent in the 1800s when farmers, with no efficient way of storing their grain, would have to accept the price given to them by buyers at ‘spot’ exchanges. Instead of farming wheat for months only for the price of the grain to fall by the time it came to harvest it, the farmer would ‘lock in’ a price with a buyer for a future date. This suited the farmer, who overcame the risk of the price of wheat falling and also suited the buyer who knew his costs in advance. In more recent times, people have used futures contracts to hedge against market movements in things like currency exchange rates.
However, futures can also be used to speculate on the direction of the market to make a profit. For example, a trader who believes the price of an asset will increase, can buy futures contracts at current market price. If their prediction is correct, they will receive the asset at a discounted price when the contract expires.
The surge in digital asset derivatives markets can partly be explained by the need for hedging against recent volatility. There is also more institutional exposure to digital asset derivatives via regulated exchanges like Bakkt & CME.
Checkout the following guides on how can you use APEX:E3 to execute effective trading strategies in derivatives markets?