Introduction to Derivatives
Traders are full of terms and phrases that you may have never heard of — or at least in the context of investments. But hey — that’s okay! The vocabulary of a trader is built over years of study and involvement in the markets. Leverj is proud to present a product by traders, for traders. Moreover, we aim to produce revolutionary tools for the cryptospace, so we would be remiss not to acknowledge that not everybody is going to know what our technical explanations mean 100% of the time. I have been lucky enough in my career to have learned much of my information from Swapman himself, so I’m prepared to shine some light for others along the way.
Let’s look at some definitions and break them down to better understand what they mean to you.
Let’s start with five terms. Derivatives, Futures, CFD, Leverage, and Spot. These are amongst the most important terms to know if you are interested in Leverj — a fact you may have already come to understand based on how often they are used in our written media.
Disclaimer:
This information is meant for educational purposes only, and should not be taken as investment advice.
1. Derivatives
Derivatives are financial instruments that derive their value from an underlying commodity. These instruments include Futures, Options, as well as others. In the current crypto markets, Derivatives are most often found in the form of Futures.
2. Futures
Futures, as mentioned above, are one specific type of Derivative. These are contracts provided with an obligation to buy or sell the underlying asset at a predetermined future date, (also know as ‘expiry.’). They come in two main forms: cash-settled and deliverable. Currently all crypto futures on the market are cash-settled to an index.
So what does this mean in crypto? Commonly you will see them labeled as “Inverse Futures” where the contracts are denominated in US Dollar, but the collateral used for both buying (long position,) or selling (short position,) is in crypto. For example, BitMEX and OKEX both offer Inverse BTC/USD Futures contracts. With both of these you are trading the value of BTC vs. USD with BTC for collateral. This means that upon settlement, (or contract expiry,) your gains will be added to your balance in BTC. Alternatively, your losses will be taken from your BTC balance.
The other type of futures you will find is a plain, linear futures contract. This is where the contract is denominated in the base currency rather than the quote currency. An example of this would be the ETH/BTC pair on BitMEX, where contracts are denominated in ETH and profits/losses realized in BTC. These non-inverse futures allow you to buy or sell an asset quoted in the currency used for collateral.To understand base currency vs. quote currency, use this simple example:
XXX/YYY
XXX = Base
YYY = Quote
3. CFD
CFD stands for “Contract for Differences.” CFD is another type of derivative that typically does not have an expiry. In crypto, with CFDs you can use Bitcoin or Ether as collateral to trade the dollar price of commodities and indices. CFDs normally have standard linear payouts on uncorrelated assets to the collateral used. This is also closely associated with “spread betting”, where there is not always an orderbook visible.
This type of instrument can be found on sites like SimpleFX. Here you may decide to trade Gold futures, denominated by their USD value. You can do this with bitcoin as collateral. All this means is that when your position is settled, your profits or losses are paid out via BTC. CFDs allow crypto holders to access legacy markets without the hassle of dealing with the banking system.
4. Leverage
Using leverage, also known as “margin trading”, is the practice of using borrowed capital as an investment strategy to increase the return potential of an investment.
Let’s say I have $10,000. I want to trade the BTC/USD pair. Assume I use no leverage and just buy 1 BTC for $10,000. The price goes to $11,000, a 10% move, and i earn $1,000 profit. (barely 0.1 BTC). A good trade, sure, but there is a more profitable way to execute.
What if I use leverage? Let’s say I put down 1 BTC collateral as my margin for a trade, then I select 10x leverage. This gives me the ability to trade in a position worth 10 BTC.
Now, I’ve opened a long position at $10k, and the price goes up to $11k (10% increase). My 10 BTC position earns roughly 1 BTC in this trade. I have used 1 BTC to double my money by trading 10x leverage on a 10% move.
Now, say I choose to open a position at 100x leverage with my 1 BTC of margin. Now my position is worth 100x my margin — in this case, 100 BTC. On that same 10% move, I can earn about 10 BTC. While this position holds an incredibly high amount of risk, I am able to use just 1 BTC to make a 10x gain.
5. Spot
The current trading price of an asset, the price at which an asset can be bought or sold with immediate delivery.
Most of you are probably familiar with spot, whether you were aware of the term or not. Spot platforms are used by GDAX, Bitfinex, and all altcoin exchanges.
With altcoin exchanges such as Binance or Bittrex, this is where you deposit your BTC or ETH onto an exchange, and purchase another crypto asset in real-time. If you place a market order, than the purchased tokens are immediately in your possession. If you place a limit order, the tokens will be in your possession as soon as your order is filled.
Spot can also refer to on-ramping your fiat into crypto. This could mean simply purchasing some BTC on Coinbase. It can also refer to intraday trading in which you buy into BTC from fiat on a dip, and sell back to fiat at the top of a range. Fiat to Crypto spot is found on exchanges that offer linking a bank account and holding a fiat balance on-site, which requires trusting the exchange.
Crypto to crypto spot can be done trustlessly, as they do not rely upon centralised bank balances to conduct trades. The recent development of atomic swaps and projects doing trustless ERC20 exchanges are making progress in this area.
And that’s just the beginning…
As we continue on this journey, further terms will be covered. Please feel free to make requests for further Trader’s Dictionary posts.