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The Short Story on Crypto Derivatives

Lite Coin? Polygon? Chainlink? These aren’t your Dad’s investments. Unless you went full hermit these last five years, you are bound to have heard about cryptocurrencies. There are an increasing number of ways to invest in crypto. Stocks and ETFs come to mind. But the one that’s been gaining traction over the last couple of years is Crypto Derivatives.

Let’s backtrack a bit if you’re unfamiliar with either term. A cryptocurrency is a digital money, as opposed to the fiat money (eg. physical notes and coins) that you use every day. Crypto has been hailed as the next step in the evolution of finance. This is because it is based on technology that makes it near impossible to forge and is accessible to anyone with an Internet connection.

Contract Between the Buyer and The Seller

A derivative, meanwhile, is a form of investment that is a contract between the buyer and seller. In this contract, what is being traded is the value of that item. The buyer and seller do not actually own it. Instead, what they have are rights to the contract which has to to be executed at a date they agree on.

The item on which the contract is based is called the underlying asset. The buyer and seller speculate on what the price of the underlying asset is likely to be at on a future date and make a profit or a loss based on that value or price.

A crypto derivative, therefore, is a contract between the buyer and seller, where the underlying asset to be traded is a cryptocurrency, like Bitcoin or some of the currencies named in our introductory paragraph.

To illustrate, two derivatives traders may meet on a platform like FTX. The buyer believes the price of a given cryptocurrency will go up in a month’s time, while the seller thinks the price will go down. They set up their contract according to those terms. On the agreed-upon date, if the price goes up like the buyer predicted, the buyer will walk away with a profit, while the seller will be in a loss position. Alternately, if the price drops, the seller makes money on the contract.

It should be emphasized that what is being traded are the contracts and not the actual cryptocurrency itself.

Advantages to Trading

There are clear advantages to trading in crypto derivatives instead of cryptocurrency stock or ETFs. With crypto derivatives, you have much more insulation against the volatility of cryptocurrencies, especially over the long term. You also need much less capital to invest in a crypto derivative. You also have an entry point into the cryptocurrencies market, without having to hold an actual cryptocurrency. You are also able to trade in a wider variety of markets with a crypto derivative.

But, as with all things, there is a downside. Because the future price of a cryptocurrency is never known in advance, and day-to-day fluctuations have sometimes been massive, the potential for short-term losses can be substantial. These may not be the best crypto investments for beginners, as they require understanding complicated investment models.

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