How to Trade Cryptocurrency Derivatives: A Beginner’s Guide

Derivatives are financial tools used to trade their underlying assets.

Definition and types of cryptocurrency derivatives

Although there are multiple types of derivatives, they are all based on the same fundamental structure: a contract between two parties. Like any legal contract, derivatives allow two parties to agree on terms to exchange value and “underlying” assets—meaning stocks, bonds, commodities, and cryptocurrencies. Traders buy and sell these contracts for agreed-upon prices (giving them their own value) which are based on changes in value of their underlying assets, and often with a significant degree of leverage.

This guide details the main concepts needed to understand how to trade cryptocurrency derivatives. It includes key terminology and explains general approaches to derivatives trading, but it is not a total strategy for implementing these complex strategies.

Types of derivatives

The derivatives market is much more mature for traditional assets (like stocks) when compared to cryptocurrencies. However, the concepts largely translate to the digital space. There are multiple types of derivatives available to trade in crypto markets:

• Futures are contracts that specify an asset’s price on a future date, allowing traders to speculate on how an underlying asset will change over time. Buyers of futures contracts are obligated to buy a predetermined amount of the asset at that set price from the seller (unless they sell the contract first).
• Options are similar to futures, as they also detail an agreement to buy/sell an asset at a certain price at a specific date in the future. However, the buyer of an options contract is not obligated (and can choose) to execute the contract before the parameters are met.
• Perpetual swaps, also called perpetual futures or simply perpetuals (perps), are more common in crypto than they are in traditional finance, and they dominate crypto derivatives trading. They allow traders to speculate on price movement of crypto assets (up/down) without a specific date in the future. Since traditional futures must be “rolled” based on their expiration dates, perpetuals are more efficient.

Key terms and concepts

Before diving into derivatives trading, there are several key terms traders should be familiar with, including:

• Leverage – One of the main uses for derivatives is to increase the opportunity to create profit. This is done through leverage, which is the strategy of borrowing funds with which to trade. In other words, leverage is trading with money that doesn’t belong to the trader. Instead, they borrow it from a broker or a pool of other traders (depending on the model). Leverage is often expressed as a ratio (like 10:1) or as a multiple (like 10x), describing the amount one can trade compared with the required funds they must put forward as collateral.
• Hedging – Another use for derivatives is to hedge. Because of their unique ability to generate profits if an asset’s price moves either up or down, traders can more discretely mitigate the risk associated with large swings in price—especially to the downside.
• Margin – In the 10:1 leverage ratio above, the “1” refers to the margin required to make the trade. Margin is the collateral put up by the trader to guarantee the borrowed funds in a leveraged trade. Trading this way is called “trading on margin.”
• Contracts – Just like the fundamental unit of stock is a share, the individual unit of a derivative is a contract. Traders can buy/sell one or multiple contracts at a time, and each contract may represent multiple units of the underlying asset (creating the opportunity for leverage).
• Liquidation – Because of the leveraged nature of derivatives, they come with more risks to both traders and the parties “fronting” the borrowed funds—often centralized exchanges or decentralized community pools of tokens. To defray this risk, derivatives markets have a safeguard. If the value of the underlying asset moves enough against a trader’s position, the trader’s collateral will be liquidated and forfeited by the trader.

Steps to start trading derivatives

Understand the market and financial tools you’re using.

Review educational materials about the derivative you’re trading (e.g., futures, options, or swaps). The platform you’re using should also have a way to learn about their specific system. Research into market trends, news, and even technical analysis often go into trade decision-making. Always understand the risk that you’re accepting with trades, whether it is with derivatives or otherwise.

Pick a platform

Some centralized crypto exchanges provide the opportunity to trade derivatives/leveraged products. Meanwhile, decentralized platforms like dYdX and Perpetual Protocol are built on existing blockchain networks like Ethereum and powered by smart contracts. Most platforms provide a user interface that is as simple as offering “long” and “short” trade options with a range of leverage. Traders are encouraged to assess platforms’ depth of liquidity (how many traders are active in trading a specific product), fee structure, regulatory compliance, and security.

Start small

It is important to learn the dangers of derivatives trading before putting a large sum of funds at risk. So, most traders start small and with a specific plan based on what they have learned from educational materials. For instance, even if a platform offers up to 20x leverage, traders may start with a relatively small 3x position to understand how their trades react to market action.

Scale responsibly

With experience comes confidence, but derivatives trading is still a risky exercise in speculation. Scaling up position size and amount of leverage must be done with caution.

Tips for beginners to minimize risk

• As stated above, start small and scale responsibly. Beginner derivatives traders must have a healthy respect for the two levers of these strategies: position size and amount of leverage. Early on, both position size (how much value per trade) and amount of leverage should be small, and they should only be increased with greater understanding of derivatives. It is also reasonable to increase either position size or amount of leverage at a time, and not increase both simultaneously with subsequent trades.
• Dedicate only a portion of your portfolio to derivatives trading. This will smooth portfolio risk, as risk exposure is higher for some funds but lower for others.
• Pick a strategy and stick to it. That means setting goals for each trade’s gains and accepting a certain stop-loss. This is especially important with perpetuals, since there is no expiration date to these derivatives contracts. By taking profits when a trade goes well, you do not risk leaving a trade “on the table” too long and erasing those profits with unexpected market moves. On the other hand, setting a maximum loss to a trade can help avoid liquidation.