Profit Potential of Crypto Derivatives

There are three ways to seek profits from assets like stocks, currencies, commodities, or cryptocurrencies. One is to buy and hold for the long term. The other is to buy and sell over the short term while trying to time the market’s ups and downs. The third is to trade derivatives of those assets with the hope of multiplying one’s profits and, hopefully, helping to manage risk. While the profit potential of crypto derivatives or other derivatives can be excellent, the risk associated with trading derivatives is sufficiently great that one can easily lose all of one’s trading capital in a very short time. In this case we are concerned about the pros and cons of crypto derivatives.

What Are Crypto Derivatives?

First of all, crypto derivatives are pretty much the same as derivatives for stocks, currencies, commodities, etc. They include futures, options, and perpetual contracts. In each case, crypto derivatives can provide leverage and/or the ability to hedge risk. While such contracts between two parties can be used successfully by those with the right knowledge and skills, they can be dangerous for the naïve first time trader who only sees the potential for a pot of gold at the end of rainbow.

Crypto Futures Contracts

A futures contract is an agreement between two parties. One party agrees to buy or sell crypto tokens such as Litecoin or Bitcoin for a set price as of a set date in the future. If the market price of the token rises above the contract price the buyer profits and if the price falls below the contract price the seller profits. The leverage in this case comes from the fact that they buyer does not purchase the tokens in question but can still make a similar profit if the price goes up. Thus the successful trader leverages his or her trading capital by making a proportionally greater profit than if they had simply bought and then sold the token. The problem for the unwary is that the same leverage will apply to losses if the trade does not work out as expected. These are short term trades in which the contract expiration date is as short as eight hours hence on most crypto exchanges as opposed to one, two, or three months with the typical futures contract for wheat, oil, coffee, S&P 500 mini futures.

Crypto Options Contracts

Unlike with futures contracts, options contracts give the buyer the option to buy or sell a specific amount of crypto tokens but do not confer any obligation to do so. Thus, an options trader will pay for the option contract and execute it only if the price moves favorably and simply walk away if the price does not move in the predicted direction. Thus the buyer of an option contract is able to leverage trading capital in a winning trade and hedge risk if the trade does not work out. However, the seller on an option contract always receives a premium for taking on the risk in this situation. If they are successful, sellers of options can routinely make small profits trade after trade. The problem is that if the token being traded moves in an adverse direction and either soars or plunges in price the result can bankrupt the seller of the option contract in one disastrous trade. Successful options traders commonly sell and buy contracts in ways that are meant to limit risk while ensuring a small but reasonable profit time after time.

Crypto Perpetual Contracts

Crypto perpetual contracts are futures contracts without a required contract expiration. A trader can hold such positions “perpetually” providing that they pay, usually every eight hours, to maintain their trading position. This approach is similar to simply repurchasing futures contracts every eight hours and has a higher “overhead” to trading than when one carefully selects a position and just places one trade.

How Profitable Can Crypto Derivatives Be?

The potential for huge profits in crypto derivatives is real. Such profits happen when the market soars or plunges, a trader has correctly anticipated such price movement and bought futures or options accordingly. It is entirely possible to multiply one’s trading capital over a short period of time. However, it is also possible to lose a multiple of one’s trading capital with an ill-advised futures contract or option contract. The crypto derivative traders who prosper over time tend to be those who use standard trading strategies that limit risk while also accepting limited profits.

Crypto Derivative Risks

If you want to trade options on stocks your broker will limit the kinds of trades that you can make. In order to make many potentially profitable but also risky trades you commonly need to have exceptional wealth as well as proof of years of trading experience and expertise. Such is not always the case when trading crypto derivatives. Therefore, novice crypto derivative traders need to beware of the risks involved, limit their position sizes, and constantly pay attention to their positions, ready to get out when things are going from bad to worse in a hurry.