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Intro to Futures, Options and Other Derivatives
By: Dorian Kandi & Matías Andrade
Key Takeaways:
Derivatives allow indirect exposure to cryptocurrencies
Derivatives allow investors to hedge against downside risk
Derivatives enable diversified trading strategies not achievable with only spot trades
Derivatives allow investors to capitalize on market inefficiencies through arbitrage.
Introduction to Derivatives
Derivatives are financial instruments that have become a cornerstone of the financial ecosystem, enabling participants to manage risk effectively and markets to function more efficiently. The global size of the derivatives market is vast, even dwarfing the size of the global equity and bond markets. Similarly, derivatives in the cryptocurrency market have evolved to provide sophisticated tools for traders and investors, offering various strategies for hedging, speculation, and risk management in this growing asset class. The primary types of derivatives in crypto are futures, perpetual futures, and options, each serving different needs.
In this week’s issue of Coin Metrics’ State of the Network we dive into the landscape of derivatives in traditional financial and cryptoasset markets, examining their types, applications and underlying data.
What is a Derivative?
A derivative is a financial instrument whose value depends on the value of one or more underlying variables. Traditionally, these underlyings are traded assets such as stocks, bonds, currencies and commodities such as gold, oil and wheat. With crypto derivatives, the value of these financial instruments are derived from the price of a cryptocurrency, such as BTC or ETH.
Types of Derivatives
A futures contract is an agreement to buy or sell an asset at a predetermined price at a specific time in the future. These contracts are standardized and traded on exchanges. Futures allow traders to speculate on the future price of a cryptocurrency or hedge against price fluctuations. Traditional futures have an expiration date, at which point the contract is settled.
Perpetual futures are similar to standard futures but without an expiry date. This means traders can hold their positions indefinitely, subject to the requirement of maintaining a margin. Perpetual futures are usually traded on margin, allowing for leverage, and are subject to funding rates, which are periodic payments exchanged between the long and short positions. These rates keep the contract price close to the underlying asset's price.
An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price before or at the contract's expiration. Options can be used for hedging or speculation. For example, a call option allows a trader to benefit from price increases while limiting downside risk, as they are not obliged to purchase the asset if it falls below the strike price.
Source: Coin Metrics Labs
The first plot illustrates the payoff for buying and selling call options. A call option gives the holder the right to buy an asset at a specified price (strike price) before a certain date.
Buying Call Options (Blue Line): If the stock price at expiration is below the strike price, the option expires worthless, resulting in a loss limited to the premium paid. As the stock price rises above the strike price, the payoff increases linearly.
Selling Call Options (Green Line): If the stock price remains below the strike price, the seller profits by the premium received. However, if the stock price exceeds the strike price, the seller faces potentially unlimited losses.
Source: Coin Metrics Labs
The second plot shows the payoff for buying and selling put options. A put option gives the holder the right to sell an asset at a specified price before a certain date.
Buying Put Options (Red Line): If the stock price at expiration is above the strike price, the option expires worthless, and the loss is limited to the premium paid. If the stock price falls below the strike price, the payoff increases linearly.
Selling Put Options (Purple Line): If the stock price remains above the strike price, the seller profits by the premium received. Conversely, if the stock price falls below the strike price, the seller incurs increasing losses.
Traders often combine options, futures, and spot instruments to tailor their exposure and manage risk effectively. For instance, miners can use futures to lock-in selling prices, and purchase options to hedge against unfavorable price movements.
Forward-looking Indicators
By design, derivatives place a forward-looking expectation on future events. The ratio of the futures price over its underlying spot price is known as the Implied Forward Rate (also referred to as “implied yield” or “basis”). This implied yield is useful for comparing returns, and expectations, across different assets. When implied yields are positive, it signifies that investors expect the value of the underlying asset to increase over the duration of the contract. Conversely, negative yields indicate that investors expect the asset’s value to decrease.
This phenomenon is illustrated in the following chart. Here, the annualized futures basis is displayed for a one-month tenor. The notable peaks and troughs reveal key insights around market expectations, with spikes in implied yields often preceding anticipated events. A significant uptick is observed from December 2023 to January 2024 coinciding with the anticipation and launch of spot bitcoin ETFs. The yield subsequently normalizes as the market digests this development. Another peak emerges in April, likely driven by expectations surrounding Bitcoin’s 4th halving event, a cyclical occurrence that typically brings increased attention towards the asset. Conversely, an abrupt downturn is evident in late 2022 as events surrounding FTX’s rapid collapse unfolded, creating a widespread impact on the crypto-asset industry.
Source: Coin Metrics Market Data Feed
Use Cases for Derivatives in TradFi
Over 20 years ago, Southwest Airlines famously launched its jet-fuel hedging program in 1994. During the Global Financial Crisis, the airline effectively hedged 70 percent of its fuel requirements at $51 per barrel; while the market price for crude oil soared to $130.
Farmers looking to secure a price prior to harvest can accomplish this by purchasing an agricultural derivative. For example, a corn producer may decide to sell a corn futures contract in May, for delivery in December. Due to fluctuations in the market price for corn, any gains/losses in the market price for corn are offset by gains/losses in the futures contract. This leaves the farmer poised to manage risks arising from falling corn prices throughout the season.
Use Cases for Derivatives in Crypto
One of the key use cases for derivatives in crypto is hedging, particularly for miners. For example, bitcoin miners invest significantly in hardware and operational costs, making them highly sensitive to price fluctuations in cryptocurrencies. They are by nature long BTC and short USD since they receive mining rewards in BTC and all their expenses are paid in USD (assuming they’re domiciled in the US). By using futures or options, miners can lock in selling prices for their mined cryptocurrencies, ensuring a predictable revenue stream and protecting against potential price drops.
In addition to miners, derivatives are also useful for investors and traders in crypto asset markets. Their prevalence is observable in the chart below, which illustrates the share of BTC volume in futures versus spot markets over time.
Source: Coin Metrics Market Data Feed
While spot volumes initially dominated, futures trading captures the majority of market activity—currently 78%. This is primarily due to factors like the robust infrastructure of centralized exchanges, tools offered by DEXs, greater regulatory clarity for futures products, and the strong appeal of leverage. As the market adapts to new investment vehicles with the launch spot bitcoin ETFs, the ratio between between spot and futures markets will continue evolving.
The role of derivatives is further evidenced by the rising levels of open interest in BTC futures across exchanges, particularly in the period surrounding the launch of spot Bitcoin ETFs. Futures open interest refers to the value of futures contracts that haven’t been settled or closed, serving as a gauge for market activity. BTC open interest hitting $30B may be attributed to investors potentially buying the spot bitcoin ETFs and hedging their exposure with futures contracts. This highlights an important use case for derivatives, as they allow investors to manage risk and strategically position themselves in the market.
Source: Coin Metrics Market Data Feed
The settlement mechanism in derivatives is crucial. In traditional markets, derivatives can be either cash-settled or physically settled. Cash-settled derivatives are settled in cash, based on the difference between the contract price and the market price at settlement. Physically settled derivatives involve the actual delivery of the asset. Most crypto derivatives, especially those in venues such as CME, are cash-settled. This means that at settlement, participants exchange the difference in value rather than the actual cryptocurrency.
Conclusion
Derivatives in the cryptocurrency market have emerged as essential tools for managing risk and enhancing trading strategies, mirroring their importance in traditional finance. They enable participants to hedge against price movements, speculate on future prices, and gain leveraged exposure to cryptocurrencies, all while typically being cash-settled to facilitate easier trading and settlement processes. The evolution of crypto derivatives has significantly contributed to the maturation of the digital asset ecosystem, providing institutional and retail investors with familiar instruments to navigate this new asset class.
Network Data Insights
Summary Highlights
Source: Coin Metrics Network Data Pro
The market capitalization of Bitcoin and Ethereum declined by 4% and 1% over the week, respectively, while several altcoins and ERC-20’s also saw contracting valuations.
Coin Metrics Updates
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