The Necessary Terminology for Investing in Cryptocurrency: Financial Derivatives
Author: Gate.io Researcher: Edward. H
Financial derivatives bring vitality to the market and convenience to people in terms of their investments. Derivatives often offer high leverage, which means high risk and high return. This article introduces common types of derivatives and their applications in cryptocurrency.
The ancient Greek philosopher, Thales, (who fell into a well because he was too intent on observing the stars) once famously said, “Know thyself”. But there is another anecdote about Thales, recorded in Aristotle’s work. That is the story of how he used options to make a profit on the olive market.
In ancient Greece, people thought that philosophers were all talk and could not make money in business. They saw philosophy as being useless. Thales could not stand it and was determined to use his knowledge to make money in business. With a wealth of astrological knowledge, he predicted the weather for the coming summer through stargazing and believed that the olive production would increase exponentially. This would lead to the market demand for olive presses to increase greatly. So he used his spare money to buy the rights to use the olive press next summer. The following summer, when the Greek olive harvest was a great success, he took the opportunity to sell the rights to the press and made a fortune. Thales is considered to be the first person in human history to successfully use options.
Modern financial derivatives such as futures and options have helped numerous people to hedge risks in the production process. Cryptocurrency are also assets that offer financial derivatives such as perpetual contracts and CBBCs. Understanding the history and characteristics of these derivatives is essential for trading cryptocurrency.
Futures and Options
The concept of futures is different to actuals or physicals, in which goods are paid and delivered at the same time. However, in futures trading, one actually trades commodities that will be delivered “in the future”. In a futures contract, the parties agree to trade a specific quantity of a commodity (contract size) at a specific time in the future (delivery/expiry date) at a specific price (delivery price).
The price of futures reflects people’s perception of the direction commodity prices will go. The price of futures tends to move in the same direction as the spot price fluctuates. The difference between the futures and spot prices is known as the basis. Theoretically, the price of futures should get closer to the spot price until it is exactly equal at the time of delivery.
By buying and selling futures, market entities can eliminate the risk of price fluctuations. They can buy or sell products at predetermined prices, and lock in profits and costs in advance. Market entities can also conduct equal and opposing transactions in the spot market and the futures market at the same time to hedge risks. The aspect of risk diversification is the most important function of the futures market.
Option is “the right to accept the future price”. When the contract buyer pays a certain premium, he/she has the option of choosing whether to follow the agreed price (also called the exercise price) within a certain period of time. According to the buying and selling direction selected by both parties, options can be divided into call options and put options. Combining the two operations of buying and selling options can be divided into four categories:
This inconsistency of rights makes the risk and return of the option buyer and seller inconsistent as well. Theoretically, the option buyer has no limit on their return. This is lower risk, but with a lower win rate; whereas the seller has unlimited risk and limited return, but with a higher win rate. Take the call option as an example, depending on the premium © as the buyer’s sunk cost, if the market price (S) is lower than the exercise price (K), the buyer can abandon the exercise of the option to reduce losses (limited risk). As long as the market price is higher than the bid price, the buyer has the incentive to exercise the option, thus gaining an uncapped return. For the seller of a call option, the maximum profit is limited. The seller may have unlimited risk as the commodity price rises. Since the seller receives a premium, a margin is required to ensure that the contract can be fulfilled when the buyer exercises the option.
This risk-controlling feature of options is similar to the property of insurance. The longer the duration of the insurance, the higher the policy price. Options also have what is known as time value. The longer the remaining contract time of an option, the longer the period of time the buyer has to hold or sell the option. Therefore, the higher the time value, corresponding to the higher price of the option.
Futures and options were originally designed for hedging, but options and futures are also speculative, which is reflected in the use of margin trading, which exponentially magnifies returns and risks.
What is Leveraging
Leveraging is to take on debt to operate, and while it magnifies returns, it also magnifies returns. A short-seller expects the price to go up, so he borrows money from others, buying more commodities (such as bitcoin), selling them when the price goes up, paying back the capital and making a profit; a short-seller expects the price of a commodity to go down, so he borrows commodities from others and sells them, buying them back when the price goes down, paying back the borrowed commodities and making a profit.
For further information:
Cryptopedia: Margin Trading
Whether the seller is short or long, when they make successful predictions, they are able to profit several times more than their initial investment from the leverage. The effect of leverage in multiplying returns and risks depends on the size of the debt relative to the principal. This is also known as leverage ratio, or ratio of principal to total capital. As an example of going long: suppose someone has 10 USDT of principal and raises 40 USDT of debt, then the total capital available to him for investment comes to 50 USDT. So his leverage ratio is 20%, and the corresponding leverage multiple is the inverse of the leverage ratio, i.e. 5x leverage.
Assuming the investor progresses well and the total capital increases by 10%, the investor’s total capital will reach 55 USDT, and after repaying 40 USDT, the principal comes to 15 USDT, while the return on the principal will be 50%. This leverages the investment return 5 times, exactly equal to the leverage multiple.
Assuming that the investor’s progress is unfavorable and the total capital is reduced by 10%, the total capital of the investor will be reduced to 45 USDT. After the 40 USDT is repaid, the principal will only be 5 USDT, and the principal will lose 50%. Therefore, leverage also magnifies the investment loss by 5 times, equal to the leverage multiple.
To ensure the safety of the lender’s funds, the principal amount in a leveraged trade is often used as margin for the trade. In the price fluctuations generated on the unrealized loss (or paper loss), the margin will be a priority deduction. With the margin down to 0 or a certain percentage, the investor must make up that margin. Otherwise it will be forced to close the position (Liquidation).
In ordinary spot trading, a poor decision does not often result in the loss of the trader’s entire capital, even if the paper loss reaches 90%! The investor can choose to hold and wait for the market to recover. In leveraged trading, depending on the leverage ratio, a 10% loss can lead to forced liquidation. The commodity will be liquidated and the investor will be wiped out, which is the biggest risk of margin trading.
For the market as a whole, too much leverage is also not conducive to supporting market prices. In an over-leveraged market, minor market fluctuations can lead to forced liquidations. This causes investors to sell more, eventually leading to an avalanche of the price.
Leverage Properties of Financial Derivatives
For financial derivatives, like futures and options, there is no formal debt raising. However, they do have the same leverage properties. As an example; in a commodity futures exchange, a minimum trading margin standard (8% for example) is often set for futures contracts. Investors need to pay only 8% of the total futures price to purchase a contract. This margin rate is effectively equivalent to a leverage ratio of principal/total capital, which is a leverage multiple of 12.5.
On cryptocurrency exchanges, there is a special form of futures contract called a “perpetual contract”. Unlike regular futures contracts, perpetual contracts do not have a delivery date and are therefore very similar to spot trading. Perpetual contracts allow for leverage of up to 100 times, providing a very high level of risk and reward. Gate.io also provides quantitative strategies, including MACD, MACD-RSI, Double Moving Average, and Double Dual Average -RSI.
Gate.io has also developed an ETF (exchange traded fund) leveraged token as a unique spot variant by using perpetual contract hedging. This category charges a daily management fee of 0.1% instead of contract market fees or funding fees. It is not subject to forced liquidation and minimizes the actual leverage overhead and risk for users. ETF leveraged tokens are currently available with 3x or 5x leverage.
For further information:
Gate.io Quick-fire Questions on Leveraged ETFs
In addition to options and futures, common financial derivatives include warrants and callable bull/bear contracts. Both can be seen as special forms of options, and both have high leverage multiples. However, CBBCs have mechanisms to help reduce investor losses, such as mandatory calls.
For further information:
Gate.io Quick-fire Questions on CBBC
Gate.io Quick-Fire Questions on Warrants
The higher the return, the greater the risk. The core of investing is to allocate one’s portfolio to maximize returns while diversifying risk. Thales said “know thyself”, which is also applicable to investors. Investors need to maintain good discipline and a steady mind in the market, while remaining confident in their own judgment. Decide on when to take profit and where to put your stop-loss and always manage risk in advance.
By Gate.io researcher Edward. H
*This article represents the views only of the researcher and does not constitute any investment advice.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.