How do crypto derivatives work?: Crypto contracts and customization

Trading cryptocurrency has security benefits over traditional investment opportunities, like non-custodial blockchain addresses that give you full control over your assets. But even with higher levels of security, more people are gravitating toward investments in crypto that don’t require purchasing it yourself, known as crypto derivatives.

Crypto derivatives are so hot that it’s common to see their trading volumes overtake traditional spot trading for cryptocurrencies on centralized and decentralized platforms alike. However, buying and selling derivatives comes with unique risks that investors need to be aware of before adding them to a portfolio.

In this guide, learn what crypto derivatives are, how they work, when it might make sense to invest in them, and when it makes sense to sit it out.

What are crypto derivatives?

Derivatives are contractual agreements to buy or sell an asset at a specific price within a predetermined timeframe. Although there are nuances between different kinds of derivatives, they always derive their value from the underlying asset and speculate on its future price. 

The only difference between crypto and traditional derivatives is that the former deals with digital assets like Bitcoin and Ethereum (ETH), and the latter deals with stocks, precious metals, or crude oil. When someone buys or sells a crypto derivative, they gain special privileges or take on responsibilities for exchanging a specific cryptocurrency. Thanks to cryptocurrency’s rise as an asset category, derivatives have become more accessible in recent years on centralized exchanges (CEXs) and decentralized finance (DeFi) protocols. 

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How do crypto derivatives work?

Crypto derivatives are a kind of financial contract, similar to stock or gold derivatives. The trader doesn’t own any crypto themselves, but the contract’s value is tied to a theoretical value of a specific kind of cryptocurrency. Two parties – a buyer and a seller – agree to fulfill lists of “if/then” provisions outlining what will happen in different situations. In addition to setting a target future price (or “strike”) for a specific amount of the chosen cryptocurrency, these contracts may include expiration dates when buyers and sellers have to settle their transfer. 

A crypto derivatives exchange may also offer opportunities for margin trading and leverage. When trading on margin, users deposit more funds than the exchange’s minimum required collateral into their trading account so they can borrow more and augment their position. For example, if a trader used 10x leverage on a Bitcoin position with $1,000 in collateral, they would instantly control $10,000 worth of Bitcoin and increase Bitcoin’s price volatility by 10. 

In the crypto market, there are three major derivative contract types, each with unique stipulations for settling transactions. 

Futures

Futures are the most straightforward of the three main types of crypto derivatives. Crypto derivatives contracts clearly detail the amount of cryptocurrency to be transferred at a strike price by a future date. If a futures contract is “physically settled,” the counterparties need to make the exchange in the underlying cryptocurrency on expiration day. But there are many cash-settled futures contracts, where buyers and sellers pay the difference in a fiat currency – like the United States dollar – equal to the strike price. 

Traders who “go long” buy a futures contract with the expectation that the underlying currency will rise in value. By contrast, “short” futures contracts only increase in value if the cryptocurrency’s market price falls below the strike. 

Perpetual swaps

Nicknamed “perps” or “perpetuals,” perpetual swaps are a special type of futures contract that doesn’t expire. Since traders don’t have to settle transactions on a specific date, they can hold perpetuals indefinitely and close their positions whenever they feel comfortable. However, traders have to agree to a funding rate mechanism for as long as they keep their positions open. If the market price for a cryptocurrency is above the strike, anyone with a long perpetual has to pay shorts, and vice versa.

Options

Unlike futures, people who buy crypto options don’t have to settle their contracts on expiration day. Instead, crypto options give holders the right to exercise their contract at the agreed-upon price. For call options, this means buying cryptocurrency at the strike. Put options give holders the right to sell digital assets at strike price. Call options gain value as the price of a cryptocurrency goes up, and puts increase as the underlying asset price drops.

Pros and cons of crypto derivatives

As trading crypto derivatives has become possible on dozens of exchanges, traders are naturally curious about using these contracts in their strategies. Crypto derivatives have valid use cases, but they aren’t ideal in every situation, and can even carry significant risks when combined with margin and leverage. 

Pros

• Market liquidity: It’s common for crypto derivatives to have higher trading volumes than physical (spot) digital assets. Some of the best crypto derivatives exchanges handle billions in contracts daily, which translates to tight bid/ask spreads, fast finality, and lower slippage.
• A way to hedge: If traders expect cryptocurrencies to dip in the near future, derivatives offer an easy way to profit from declines. Investors who want to reduce their cost basis might use short derivatives to “hedge” positions during declines while holding crypto for the long term. 
• Amplified trading power: The draw of using strategies like leverage and margin is that they’re incredibly capital efficient. With a relatively small amount of collateral, anyone could control big positions in the crypto market and potentially take advantage of price fluctuations. 
• Multiple strategies: Derivatives come with various specifications tailored to different trader preferences. From cash and physical settlements to fixed or indefinite expiry dates, there are many ways to mix-and-match stipulations in different contracts to find a suitable agreement. 

Cons

• Amplified risks: A major drawback of using leverage is that it opens the possibility of losing everything (liquidation). Because margin positions move wider than regular market prices, there’s a price above $0 where traders have to forfeit all their collateral without hope of recovery.
• Complex rules: Derivatives aren’t as intuitive as buying and selling spot cryptocurrencies. Though the rules and contract types give traders more options, it takes time and practice for traders to learn their rights and obligations as derivatives holders. 
• Short duration: Even perpetuals are typically used for trading rather than long-term investing. People interested in crypto derivatives generally only use these contracts for a trade set-up within a short window, which makes them poor choices for multi-year investments.
• Active management: Derivatives are more sensitive to short-duration price fluctuations. If traders want to avoid potential problems like liquidation, then they need to be proactive and research risk management strategies like stop-losses and take-profit orders. 

Filing crypto taxes? CoinTracker can help

If you’re trading or using cryptocurrencies, tax authorities like the IRS need a complete breakdown on your income, gains, and losses. You could calculate all of these transfers manually, but it gets increasingly complicated the more exchange accounts and wallets you have. Factor in recurring purchases from dollar-cost averaging (DCA) or activities like staking and yield farming, and doing taxes for your trading might feel like another full-time job.

Take the stress out of filing crypto taxes and download CoinTracker’s Portfolio Tracker for real-time updates on every crypto transfer between exchanges, wallets, and smart contract protocols. CoinTracker can import all of this data into IRS-compliant forms like Form 8949 that are ready to ship directly to a CPA, TurboTax, or H&R Block.

See why millions of crypto investors already use CoinTracker's services to simplify tax reporting. 

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.