What Are Derivatives
Definition of Derivatives
Derivatives are financial contracts whose value is derived from the price of an underlying asset. With Bitcoin derivatives, instead of buying and selling actual Bitcoin, you trade contracts that bet on Bitcoin's price movements.
In spot trading, when you buy 1 BTC, you actually own 1 BTC. With derivatives trading, you can invest in price increases or decreases without directly holding BTC.
Spot Trading vs Derivatives Trading
| Aspect | Spot | Derivatives |
|---|---|---|
| Holding | Actual coins | Contract (position) |
| Direction | Buy only (long) | Buy (long) + Sell (short) |
| Leverage | None (1x) | Up to 1-125x |
| Expiry | None | With or without (perpetual) |
| Settlement | In coins | Can be in USDT or other stablecoins |
| Risk Level | Losses limited to investment | Losses can exceed investment |
The biggest differences are directionality and leverage. With spot, you only profit when prices rise, but with derivatives, you can profit from falling prices too (short position). Using leverage allows you to control large positions with small capital, but risk increases proportionally.
Types of Derivatives
Futures Contracts
Contracts to buy or sell an asset at a predetermined price at a specific future date. A long-established product in traditional finance, the CME (Chicago Mercantile Exchange) Bitcoin futures are a prime example in cryptocurrency.
- Has expiration: Quarterly (March, June, September, December) or monthly expiry
- Settlement method: Physical delivery (actual BTC) or cash settlement (USD difference only)
Perpetual Contracts
Futures contracts with no expiry date, the most traded derivatives product in cryptocurrency markets. Offered by most crypto derivatives exchanges including Binance and Bybit, they account for the majority of all derivatives volume.
- No expiration: Maintain positions as long as desired
- Anchored to spot via funding rate: Fees exchanged between longs and shorts every 8 hours
Over 90% of cryptocurrency derivatives trading is in perpetual futures. When people say "futures trading," they usually mean perpetual futures.
Options
Contracts that trade the right to buy (call) or sell (put) an asset at a specific price. Since it's a right rather than an obligation, you can choose not to exercise if unfavorable.
- Call option: Bet on price increase
- Put option: Bet on price decrease
- Major exchanges: Deribit, OKX, Binance Options
Options have more complex structures than futures but are very useful hedging (risk management) tools. Covered in detail in Options Basics.
Why Trade Derivatives
1. Short Positions (Investing in Declines)
With only spot holdings, there's nothing you can do when prices fall. Short positions in derivatives allow you to pursue profits even in bear markets.
2. Leverage (Capital Efficiency)
With 10x leverage, you can open a $10,000 position with just $1,000. If price rises 5%, spot yields $50 profit, but 10x leverage yields $500. Of course, losses are also 10x if price moves against you.
3. Hedging (Risk Management)
When holding Bitcoin long-term but expecting a short-term decline, you can open a short futures position to offset spot losses. This is one of the main reasons institutional investors use derivatives.
4. Arbitrage
You can pursue risk-free profits by exploiting price differences between spot and futures, or price differences across exchanges. Funding rate arbitrage is a prime example.
Size of the Derivatives Market
The cryptocurrency derivatives market is larger than the spot market. As of 2024, daily derivatives volume is approximately 3-5 times spot volume.
A higher ratio indicates the market is driven by leverage, which can increase volatility. When derivatives volume is excessively high relative to spot, the market is interpreted as having strong speculative characteristics.
Risks of Derivatives
Liquidation
When using leverage, if price moves against you beyond a certain level, you face forced liquidation. You can lose your entire deposited margin. Covered in detail in Liquidation Mechanics.
Excessive Leverage
High leverage causes significant losses from small price movements. With 100x leverage, a 1% price change becomes 100% profit or loss. Given cryptocurrency's high volatility, this is extremely dangerous.
Fee Burden
Derivatives trading incurs funding fees in addition to trading fees. The longer you hold a position, the more funding fee accumulation can erode profits.
Market Manipulation Risk
Derivatives on low-liquidity coins are vulnerable to price manipulation by large players. "Stop hunting" - intentionally triggering cascade liquidations through sudden price moves - can occur.
Using Derivatives Data on BitInsight
BitInsight provides real-time derivatives data for 8 major coins (BTC, ETH, SOL, XRP, DOGE, ADA, AVAX, LINK).
- Funding Rate: Market's long/short bias
- Open Interest: Total position size open in the market
- Long/Short Ratio: Distribution of trader position directions
Observing these three indicators together allows you to assess the derivatives market's overheating/cooling state and obtain useful market sentiment signals even for spot investing.
Summary
Derivatives are financial contracts that invest in price movements without directly holding the underlying asset. They enable strategies impossible with spot trading - short positions, leverage, and hedging - but come with risks of liquidation and excessive leverage. Perpetual futures dominate cryptocurrency trading volume, and derivatives market data provides important market sentiment indicators even for spot investors.
Next article: Futures Trading Basics - Contracts, Margin, and Leverage