Bitcoin derivatives, such as futures and options, can initially seem intimidating. However, these Bitcoin Indicators and trading tools can help investors manage risk and capitalize on price fluctuations. If you have ever felt anxious watching Bitcoin's price swing up and down, Bitcoin derivatives can help you minimize some of the risks associated with that volatility. Learn how to trade Bitcoin derivatives to maximize your potential gains while minimizing your risks.
One way to start is by checking out Bitcoin Magazine Pro’s Bitcoin analysis. This tool can help you understand Bitcoin’s price action and derivatives, giving you the insights you need to trade confidently.
What Are Bitcoin Derivatives & How They Work
Bitcoin derivatives are financial contracts whose value derives from Bitcoin's price. The most common types of Bitcoin derivatives are Bitcoin futures and Bitcoin options.
Derivatives allow traders to speculate on Bitcoin's future price movements without owning any Bitcoin. If a trader thinks Bitcoin’s price will go up next week, they could buy a Bitcoin futures contract or a Bitcoin call option.
Profiting from Volatility
If the price of Bitcoin rises as expected, the trader can sell the derivative for a profit— even though they never owned any Bitcoin.
Bitcoin derivatives also allow traders to profit in falling markets. If a trader thinks Bitcoin’s price will decline, they can sell a Bitcoin futures contract or a Bitcoin put option.
Hedging Against Losses
If Bitcoin’s price drops as expected, the trader can buy back the derivative for a profit. Again, since they never owned Bitcoin, they avoid the associated transaction fees and custody issues.
In the Bitcoin derivatives market, these contracts can have slightly different prices than the Bitcoin spot price. Bitcoin derivatives also allow traders to do insane amounts of fast short-term trading to capitalize on small price fluctuations.
Trading Bitcoin Derivatives vs. Owning Real Bitcoin
The quickest way to gain exposure to Bitcoin's price movements is to own real Bitcoin. This means you own a portion of the 21 million Bitcoin that will ever exist. If you can transfer the asset to a private wallet, you can rest assured that you own actual Bitcoin.
If you own Bitcoin in exchange, you sacrifice some autonomy over your asset. The exchange controls your private keys, and if it suffers a hack or goes bankrupt, your Bitcoin could be lost. To truly own your Bitcoin, you must transfer it from the exchange to a wallet you control.
Blockchain Transparency
This transaction will be recorded on the blockchain, which is the ultimate authority on asset ownership.
An alternative way to gain exposure to Bitcoin's price is to own derivative or synthetic products. These derivative products change prices based on their underlying asset, Bitcoin.
Ownership Limitations
Several significant differences exist between owning a Bitcoin derivative and owning real Bitcoin.
Since the derivative is not real Bitcoin, the owner cannot spend or transfer funds on the blockchain. This means that the derivatives must remain under the control of the company that issued them.
Centralized Control
For many people, part of Bitcoin's appeal is its autonomy from legacy financial institutions. Bitcoin derivatives diminish this autonomy.
Derivative products have a greater counterparty risk because they are tied to a specific company. If the company becomes insolvent or dishonest, your investment may be lost even if the price of Bitcoin indicates that it should be valuable.
Counterparty Risk
The company offering the derivatives is almost certainly hedging its position to limit risk as the Bitcoin price fluctuates. This hedging may be imperfect, or the company could fail for other reasons.
The Bitcoin Derivatives Market
When Bitcoin was created in 2008, it was only known to a small group of early adopters. There were no formal exchanges, so the easiest way to get Bitcoin was to mine it on your computer.
As Bitcoin grew, exchanges were created to facilitate currency transfer. Over time, these exchanges were joined by increasingly efficient financial institutions that offered improved functionality to their clients.
Market Liquidity
The Bitcoin market has sufficient liquidity for almost all traders, and new Bitcoin products are constantly being added to product offerings.
Market investors need to understand the products they are buying in order to assess the potential risks and rewards.
Diverse Trading
Despite these drawbacks, Bitcoin derivatives do offer some compelling benefits. Some Bitcoin derivatives trade on stock exchanges, along with more traditional equities.
This can benefit traders better positioned to interact with these markets than traditional Bitcoin markets.
Institutional Access
Many institutional investors have restrictions on where they can allocate their investments, and financial derivatives may be more accessible than direct ownership of Bitcoin.
Derivative products can also allow investors to leverage or hedge their positions in impossible ways with direct Bitcoin ownership. Derivatives with very high liquidity may be well suited for high-frequency traders looking to minimize slippage.
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What Are the Different Types of Bitcoin Derivatives?
Bitcoin Futures: Understanding the Basics of This Popular Derivative
Bitcoin futures are financial derivative contracts that oblige the holder to buy or sell Bitcoin at a predefined price by a specific date in the future. Bitcoin futures contracts may be settled in cash or Bitcoin, allowing investors to bet on Bitcoin's price development using leverage.
Traditionally, futures were primarily used to hedge commodity positions, but they have become popular investment vehicles for speculators.
Shorting Bitcoin
Investors who want to go short on an asset can sell futures. Bitcoin futures can be traded on the Chicago mercantile exchange or derivatives trading platforms such as:
- BitMEX
- Deribit
- Quedex
Perpetual Bitcoin Futures: One of the Hottest Products
Perpetual Bitcoin futures (also known as perpetual swaps) function the same way as normal Bitcoin futures, with the key difference being that they have no fixed maturity date (hence the term perpetual).
Perpetual Bitcoin futures have Bitcoin as their underlying asset and are settled in Bitcoin, which means investors do not touch fiat currency in the transaction.
This can help traders in certain jurisdictions. Perpetual Bitcoin futures enable traders to use leverage to bet on Bitcoin's price development. This is why perpetual futures have become so popular on the Bitcoin derivative exchange BitMEX, which pioneered this financial product in the digital asset market.
Bitcoin Options: Another Popular Derivatives
Bitcoin options give traders the right, but not the obligation, to buy or sell Bitcoin at a specific price at a predefined time. Options are an excellent way to bet on a Bitcoin rally in the near future with only a small amount of available capital.
Hedging with Puts
Should the market (and thus your portfolio) drop by 50 percent, your portfolio would lose around 50 percent, but your put option would be “in the money,” reducing the impact of the market drop on your portfolio.
If you want to bet on the price of Bitcoin “mooning” in the coming months, you could buy a September call option on Bitcoin with a strike price of $14,000 on Quedex.
Profiting with Calls
Should the price rally above $14,000 to $15,000, your call option will be in the money by $1,000 minus the premium (the price) paid for it. Currently, the two leading Bitcoin options trading platforms are Deribit and Quedex.
Binary Options: The Riskiest Way to Trade Bitcoin
Binary options are financial derivatives that enable traders to bet on whether the price of an asset will end up higher or lower at a predefined time in the future. The outcome of these markets is binary; either you win and earn a return, or you lose all your invested capital.
Binary options are among the riskiest investment vehicles in the financial markets; thus, they are not recommended for newcomers to trade Bitcoin. An example of a Bitcoin binary options trade would be to go long a binary options market on Bitcoin with an end-of-day expiry.
Simple Betting
That means if the price of Bitcoin ends up higher than it traded at the launch of this specific market, then you win a fixed amount determined by the market. If the binary option is trading at 65/35 and you buy the option, you can gain 35 cents on the dollar if the price closes above the strike price.
You lose your entire invested capital if the price closes lower at the end of the binary options market. Several online brokerages offer binary options on Bitcoin.
Unregulated Brokers
It is crucial to note that binary options brokers are often not regulated. Because this type of derivative is risky, only experienced investors who fully understand all the risks involved should gamble on Bitcoin with this financial product.
Bitcoin Variance Swaps: The New Kid on the Block
A Bitcoin variance swap is a financial derivative with Bitcoin's annualized variance (i.e., volatility) as its underlying market. The swap enables one of the two parties involved in a transaction to pay an amount based on Bitcoin's variance (volatility).
The second party will pay a fixed amount (known as the strike price) determined at the beginning of the transaction. Bitcoin variance swaps can be used to hedge or bet on Bitcoin's volatility.
Hedging Volatility
If a naturally long digital currency company wants to hedge against market volatility, it could purchase a Bitcoin variance swap to lock in the BTC volatility to prevent market movements from affecting profitability.
Bitcoin variance swaps were introduced by algorithmic digital asset trading company GSR Trading in April 2019. The Hong Kong-based company is a market maker for this new Bitcoin derivative, targeted at institutions and companies, not retail traders.
Why Do Some People Trade Bitcoin Derivatives, Not Bitcoin?
Traders can multiply their profits when trading Bitcoin derivatives. When speculating on the future price of Bitcoin, you can either go long or short on contracts. This means you can profit even when the cost of Bitcoin is falling.
Leveraged Trading
Bitcoin derivatives trading allows traders to use leverage to maximize their profit potential. For example, if you use 10x leverage on a Bitcoin derivatives trade and the price of Bitcoin moves in your favor by 10%, your return on investment (ROI) will be 100%.
While it’s possible to replicate this with spot trading, it would require a much larger upfront investment.
Get Started with Bitcoin Derivatives Trading with Less Capital
Bitcoin derivatives trading allows you to get started with less money than trading Bitcoin itself. To open a $10,000 position on a spot trade, you must have $10,000 in your account.
If you want to open a $10,000 position in a Bitcoin derivatives trade with 10x leverage, you’ll only need $1,000 to get started. This makes derivatives trading much more accessible to new and smaller investors.
Save Money on Transaction Fees
When trading Bitcoin directly, you must pay network transaction fees every time you buy or sell.
These fees can add up quickly, especially for active traders who might execute dozens of trades in a single day. With Bitcoin derivatives trading, you don’t have to worry about these fees.
Bitcoin Derivatives Trading Is Regulated
You might think that the complexities of Bitcoin derivative trading could mean it’s difficult for regulators to monitor. The opposite is true.
The Securities and Exchange Commission (SEC) permitted hedge funds and other financial institutions to offer products based on Bitcoin futures in the United States.
Indirect Exposure
They denied using Bitcoin itself to derive their products. The products in question are Bitcoin exchange-traded funds (ETFs) and trusts that indirectly allow high-net-worth investors to gain exposure to Bitcoin.
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Pros & Cons of Investing in Bitcoin Derivatives
Bitcoin derivatives help stabilize the market. Since these contracts essentially take advantage of arbitrage, they help ensure that Bitcoin's market prices are accurate. Bitcoin derivatives also generate trading volume that enhances market liquidity and helps Bitcoin reach a state of equilibrium.
Cost-Effective
Bitcoin derivatives are great risk management tools. Unlike trading Bitcoin spot markets, derivatives can help reduce market transaction costs.
Bitcoin derivative contracts are cheaper to trade than securities like spot trading because they can minimize risks associated with the fluctuating prices of Bitcoin. If you purchase a Bitcoin derivative contract and the Bitcoin price falls, you can offset the losses with gains from the derivatives.
Market Sentiment
Bitcoin derivatives can help traders understand Bitcoin price movements. Since the value of Bitcoin derivative contracts is tied to Bitcoin, they help traders minimize portfolio risks. The market also helps generate market movement sentiment, providing hints concerning trading strategies.
What Are The Downsides of Using Bitcoin Derivatives?
Bitcoin derivatives can be very volatile at times. Since Bitcoin's value fluctuates frequently, traders are at risk of losses, particularly in the case of leveraged contracts.
In some parts of the world, derivatives trading is illegal. Two parties participating in a future contract must be where derivatives trading is legal.
How to Invest in Bitcoin Derivatives
Like any financial derivatives, Bitcoin options allow traders to speculate on Bitcoin's future price without buying or selling the underlying asset directly. They offer traders a way to bet on Bitcoin’s price movement.
To understand how Bitcoin options work, here's a basic example: Each options contract has an expiry date, and depending on the type of options contract (American or European), the contract must be executed before or by that date.
Understanding Options
Suppose an investor buys a Bitcoin call option at $50,000, for which they pay a premium of $800. If Bitcoin’s price drops to $40,000, the investor can opt not to exercise the option, avoiding a $10,000 loss but forfeiting the $800 premium.
In another scenario, if the investor buys a Bitcoin call option at $20,000 (known as the strike price), and the price of Bitcoin rises to $25,000, the investor may exercise the option, potentially making a $5,000 profit minus the premium and any additional fee.
Key Terms for Understanding Bitcoin Options
There are three terms used for Bitcoin options pricing, including:
1. In the Money (ITM)
In the money refers to executing the option for a profitable trade. A call option is ITM when the market price of Bitcoin exceeds the option's strike price. This implies that if the option is exercised, the option holder may purchase Bitcoin for less than its current market value, which might result in a beneficial scenario.
A put option is ITM when the market price of Bitcoin is lower than the option's strike price. This allows the option holder to sell Bitcoin at a price above the current market value, which can be profitable if the option is exercised.
2. At the Money (ATM)
At the money, it isn’t about making a profit or a loss on the options contract but taking advantage of it when it becomes profitable.
A call or put option is ATM when the market price of Bitcoin is equal to the strike price. While there’s no immediate profit to be made from exercising the option, it’s on the brink of becoming profitable with any upward movement in the market price.
3. Out of the Money (OTM)
Out of the money refers to executing a trade that’s not profitable. A call option is OTM, when the market price of Bitcoin is lower than the strike price.
Exercising the option would result in a loss because the option holder would buy BTC at a price above the current market value. A put option is OTM, when the market price of Bitcoin is higher than the strike price.
Option Premium
In this case, exercising the option would result in a loss because the option holder would be selling Bitcoin at a price below its current market value.
The premium, which is the price or fee for buying the option contract, is calculated based on the asset's price, market volatility, the length of the contract and the strike price. It will also depend on whether the option is:
- ITM
- ATM
- OTM
Start Trading Bitcoin Options in Simple Steps
Trading and their derivatives, like Bitcoin options, involves significant complexity and risk. There are also risks in buying (and owning) and selling directly, for example, on a digital coin exchange.
Newcomers to the market often start by engaging in direct trades on exchanges to familiarize themselves with the market dynamics before delving into the more complex world of derivatives and options trading.
Option Premium
Many platforms offer demo accounts for those interested in exploring Bitcoin options and derivatives. These accounts allow beginners to learn about the intricacies of derivatives trading in a risk-free environment, using simulated funds instead of real capital.
Bitcoin Options Trading Platforms
Bitcoin options trading can be available on traditional derivatives platforms, offering exposure to other assets, like stocks or gold. Options trading is also available on some major exchanges, including:
- OKX
- Bybit
- Binance
- Coinbase
- Kraken
Investors may start Bitcoin options trading on a familiar platform or open a new account on a reputable platform or exchange known for its robust trading features.
How to Trade Bitcoin Options
This is the typical route an investor or trader will take to buy or sell Bitcoin options once they understand how derivatives and options work and have decided on a strategy to suit their risk tolerance. The steps will vary according to the type of contract, its terms and the platform.
- Step 1: Carefully choose a platform or exchange, considering factors such as security, fees, available contracts, and user interface.
- Step 2: Sign up and complete any verification processes the chosen platform requires.
- Step 3: Deposit funds; it will depend on the platform’s requirements.
- Step 4: Locate the derivatives or options section on the platform and familiarize yourself with the interface and the types of options contracts available.
- Step 5: Choose a call or put option based on your trading strategy, market analysis, and understanding of options contracts. Consider fundamentals like strike price, expiry date, and premium.
- Step 6: Enter the details of your trade, such as the contract size (number of options) and the price you’re willing to pay. Review and confirm your order.
- Step 7: Monitor the market, contract or “position” to stay informed.
- Step 8: Depending on market conditions and your strategy, decide whether to exercise the option (if ITM and it’s an American option), hold it until expiry, or sell the option contract before expiry to close your position.
Bitcoin Options Strategies
One way investors use Bitcoin options contracts is to hedge on the expected price of Bitcoin, a risk management strategy used to offset potential investment losses.
Investors looking to hedge against potential price decreases in Bitcoin might purchase a put option. This option allows them to sell Bitcoin at a predetermined price, protecting them if the market price falls below this level.
Call Options
Conversely, investors optimistic about Bitcoin’s price might buy a call option, giving them the right to purchase Bitcoin at a set price in the future. If the market price exceeds this level, they could potentially profit.
Advanced Bitcoin Options Trading Techniques
There are many advanced Bitcoin options trading strategies for experienced Bitcoin options traders with multiple positions and contracts in play to balance their risk. These include the:
- Covered call
- Protective put
- Long call spread
- Long put spread, to name just a few
Trading Strategies
A covered call is a strategy of holding the underlying asset (Bitcoin) while selling a call option. Income can be earned from this, but the upward potential is limited.
A protective put strategy involves purchasing a put option and owning the underlying asset to hedge against a significant price decrease.
Trading Spreads
Spreads known as long call and long put entail purchasing and selling options with various strike prices or expiration dates to control the investment’s cost and specify possible gains and losses.
Successful traders deeply understand the markets and Bitcoin derivatives trading products, including how to buy and sell Bitcoin options effectively. They develop a carefully planned strategy and know their risk tolerance, ensuring they only invest what they can afford to lose.
Risk Management in Bitcoin Options
Bitcoin options may attract institutional investors, as derivatives are a more familiar investment mechanism. If they are settled in cash, the investor can speculate on Bitcoin price volatility without owning Bitcoin itself.
Like other investments, Bitcoin options have risks. The main risk is Bitcoin's extreme price volatility, which can result in significant value losses should the market move unfavorably.
Trading Spreads
Due to the market's lack of regulation, there is a greater chance of fraud and market manipulation. Various tactics are available to investors to help them manage these risks. Spreading investments over different assets can help reduce the impact of a single asset’s poor performance, which is why diversification is so important.
Setting stop-loss orders allows the automatic sale of holdings at a preset price and can help limit losses.
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Bitcoin derivatives are financial contracts whose value is derived from the price of Bitcoin. The most common types of Bitcoin derivatives are futures and options, which allow traders to go long or short on Bitcoin’s price with a predetermined settlement date.
Futures Expiration
Futures and options are among the most popular trading tools in the Bitcoin market and significantly impact Bitcoin’s price and volatility.
Bitcoin’s price tends to drop leading up to the expiration of futures contracts, as the open interest of these contracts is reduced. This can trigger cascading sell-offs, especially if the market is heavily leveraged.
Types of Bitcoin Derivatives
Bitcoin Futures
Bitcoin futures are contracts that allow investors to buy or sell Bitcoin at a predetermined price on a specific date. Bitcoin futures were first listed on traditional exchanges in late 2017, and since then, the market for Bitcoin futures has grown substantially.
Trading Bitcoin futures allows investors to hedge against price fluctuations in the Bitcoin spot market. The contracts trade on regulated exchanges, providing transparency and mitigating counterparty risk.
Bitcoin Options
Bitcoin options are similar to futures, allowing investors to buy or sell Bitcoin at a predetermined price. Unlike futures, options contracts do not obligate the holder to execute the trade.
Instead, Bitcoin options give the holder the right to execute the trade before the contract expires. This feature allows for greater flexibility when trading Bitcoin’s price volatility.
The Benefits of Trading Bitcoin Derivatives
Derivatives allow for greater flexibility when trading Bitcoin’s price volatility. They enable investors to:
- Hedge against price fluctuations
- Reduce their risk exposure
- Enhance returns
Because derivatives are typically traded on regulated exchanges, they provide transparency, improve liquidity, and mitigate counterparty risk.