Know the Risks and Rewards of Crypto Derivatives Trading

 

History of Futures Contracts
(The Derivative of the Derivatives)

Futures trading dates back to the 1800s and has considerably evolved since then.  The prior purpose of futures markets heavily revolved around the need for price stability for producers and purchasers of commodities. Such commodities include wheat, grain, and metals.

The rationale behind this was to lock in prices at an earlier date to mitigate volatility within the markets. Market prices constantly fluctuate and the guarantee of a specific price today gave the producers greater certainty and confidence within their operations. E.G a farmer could guarantee a price today before the crops were fully grown and sell them at the delivery date for the agreed upon price. 

However, in the present day, futures can be seen more as a financial instrument that facilitates the assetization of a commodity with reduced concern for the trading participants as described in the earlier days. In turn, a systemic change in these markets has occurred; whilst they are still used to hedge and manage risk, they enable traders to gain exposure to certain markets and present the opportunity to speculate and evolve trading strategies for financial gain.

 

What is Crypto Derivatives Trading?

Crypto derivatives are a type of financial derivative contract that obtain their price from an underlying cryptocurrency. Each contract has two sides where someone can either adopt a long or short position on the contract. The incentive behind this is to speculate on the underlying assets' price on a future date.  It is important to note that different traders have different incentives behind entering such positions, inclusive of profiting from short-term drawbacks in the market or mitigating risks in their long-term positions. 

 

2 Examples (With and Without Price information):

Example 1: 

Bob speculates an increase in the underlying and thus adopts a long futures position, on the other hand, Sally has a more bearish perspective of the market and thus takes a short futures position. In this example, there are 2 parties that are counterparties to one another. Focusing back on the rationales as discussed above, Sally decided to take on this trade as she is long the underlying in her spot portfolio and seeks to mitigate a drop in her Profit and Loss (PnL).

Example 2:

Bob and Sally enter a futures contract taking opposing sides with Bob being long and Sally being short. They enter a contract with the underlying asset being Ethereum (ETH)  at $1,400. Bob speculates a price increase in a month (expiry date). In essence, Bob will have to pay $1,400 in a month, regardless of ETH’s price within a month. Sally on the other hand is committed to selling Ethereum at $1,400 in 1 month. If the price of Ethereum was to increase by 30% to $1820 at the expiry date, Bob will be purchasing Ethereum at a discounted rate, specifically $420 cheaper (excluding trading fees). Alternatively, if ETH was to drop by 30% to $980, Bob would still have to purchase at the $1400 mark, resulting in Sally selling the asset at a premium to Bob.

 

A Table Highlighting the Financial Effect on Both Participants from the Example

 

*At expiry
** Excluding trading fees 

Crypto Derivatives Contracts with Leverage

Cryptocurrency futures are a form of trading in which traders can bet on the future value of cryptocurrencies. In traditional finance, margin trading refers to when an investor borrows money from a broker to purchase more shares than they could afford on their own. The borrowed money is known as the margin. When margin trading, you are using borrowed assets, or leverage, to enhance overall capital efficiency which can increase your potential profits (or losses).

In the cryptocurrency space, margin trading is often used to increase the trader's exposure to a particular digital asset, which can result in greater profits if the market follows the direction of the trade within the futures contract. For example, using the table above, if Bob was to make $420 when unleveraged if he was 5x, he would stand to make $2100. This is all subject to transaction costs. To understand this better, think of Bob as trading with 5 times the amount of capital to his actual investment.  Instead of purchasing 1 contract, he purchased 5 thus ($420*5 =$2100).

On the other hand, if the market moves in the opposite direction to the trade placed on 5x leverage they would lose a more significant chunk of their capital when compared to an unleveraged/ lower leverage tier trader. This is since smaller market movements in the adverse direction to Bob's trade will be multiplied by 5. To illustrate this, a 4% move to the negative would be the same as a 20% loss:

4% Loss on a $1400 ETH futures contract = $56 Loss ($1400 * 0.96)

$56 Loss on each contract (*5) = $280… $1400 - $280 = $1120

$1120/ $1400 = 80% Initial capital remaining 

 

What are Perpetual Contracts?

Perpetual futures contracts are a variation of the typical standard futures contract. The distinct feature between a traditional futures contract and a perpetual futures contract is the absence of an expiration date. This results in traders being able to maintain their positions, either short or long and not being forced to close out a position owing to the time variable. To ensure the prices stay in line with the spot market of the underlying asset, a funding rate is used, which is paid between the buyers and sellers of the contract to maintain a close distance from the spot price. This is determined by the overall demand for both short and long positions.

There is much misconception around this topic and thus it is important to clarify that the funding rate is not a fee charged by the exchange nor an interest payment. It is simply a mechanism to ensure the futures price automatically showcases the index price. If the perpetual contract is trading higher than the spot index, the funding rate will be positive and can be attributed to bullish market sentiment as there is greater demand for long positions, hence longs pay shorts. The rationale behind this is to reduce the incentive to be long and encourage traders to take on short positions to receive this payment. Conversely, when the Perpetual contract is less than the spot index, the funding rate will be negative, incentivizing long positions as they will receive a fee from short contract owners. From this, there is the opportunity to economically streamline your portfolio when hedging certain positions. For example, if a trader was to long Ethereum in Spot but short Ethereum in the perpetual futures market, they can earn a funding rate. 

 

What Are The Key Benefits?

OPNX is a crypto derivatives exchange that allows users to trade deliverable perpetual futures contracts.

The benefits of a perpetual futures contract include the ability to trade on margin and take advantage of price movements in the underlying asset. This is referred to as improved capital efficiency.

OPNX users can trade cryptocurrencies with leverage and take delivery (crypto into their wallet or OPNX account) of leveraged positions at any time.

You can earn funding whilst hedging your positions when mitigating risk. 

Types of Crypto Derivatives

There are a variety of different types of crypto futures contracts available to traders. Most commonly, traders will use the following:

Spot Futures: These are futures contracts that track the underlying asset's spot price (the current market price). The contract will expire at a certain date and time, with the holder receiving or paying out based on the difference between the current price and the futures contract's settlement price.

Forward Futures: These are similar to spot futures, except they do not follow the underlying asset’s spot price but rather the expected future prices. They are often used to hedge against market movements in certain cryptocurrencies.

Margin Trading Futures: These futures contracts enable traders to use their existing holdings as collateral for additional trades. This type of contract often comes with high leverage and can be used to increase the size of a trader’s positions without having to put additional capital at risk. Cryptocurrency markets are extremely volatile and thus if the trade is in the opposite direction to the market, the following actions may occur: 

1. More collateral is needed to be posted
2. Reduce notional position size (Lower the amount of leverage used)
3. Risk of liquidation 
   

    

Four Key OPNX Metrics Every Crypto Derivatives Trader Should Know

Leverage

In trading, leverage refers to how much buying power someone wishes to use through borrowed capital. While leverage magnifies gains, it also magnifies losses and puts traders at risk of liquidation. This is detailed with an example under the ‘Crypto Derivatives Contracts with Leverage’ section. 

Position Margin

Position margin refers to the initial margin required to place an order and open a position. Remember, the margin is the amount of money that you need to borrow from the exchange in order to buy or sell assets.

On OPNX, when you place an order, the system will check whether you have sufficient collateral to cover the position margin. If you have insufficient collateral, you will be required to add more, or take on a smaller position. When the order is accepted into the order book, this margin will be isolated and unavailable until the order is canceled. Once the order has been matched, the isolated margin will become the position margin. Margin can be added or withdrawn from the position margin.

Margin Balance

Margin balance corresponds to the real-time margin used to support your open position and is calculated by taking the sum of all position values (unrealized profit and loss) and subtracting any outstanding borrowings (position margin).

Maintenance Margin

Maintenance margin refers to the minimum amount of margin required to keep a position open. 

On OPNX, positions are liquidated (automatically reduced/closed) when a position’s margin balance falls below the maintenance margin. If a trader’s margin balance enters bankruptcy, then the position may be auto-deleveraged (ADL) if the insurance fund cannot support the loss.

 

Final Things to Note

• Trading a derivatives contract does not mean you own the asset, rather it is financial contract that enables a trader to gain exposure to price movements of an underlying asset
• With high volatility in the crypto market and access to leverage, it can be either a recipe for great profits or heavy losses. Despite the improved capital efficiency, having a robust risk-management strategy is critical in avoiding the latter.
• Unlike spot, the trader has access to speculate on both up and down movements
• Derivatives markets are a great way to hedge/ mitigate price movements to the downside and when implemented correctly, they can help reduce losses.
• In perpetual futures, funding rates fluctuate, meaning at the rollover point to keep your contract going you will earn a small fee from the counterparty or have to pay the funding rate.

Ready to trade on OPNX? Sign up and join our OPNX Affiliate Program to earn 30% commission on spot and futures trading fees.