In the world of finance, a derivative is a contract whose value is derived from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often referred to as the “underlying.” Derivatives can be used for a number of purposes including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
There are two main types of derivatives:
- Futures/Forwards: These are contracts to buy or sell an asset at a specified future date at a price that is agreed today. The buyer of a futures contract is taking on the obligation to buy the underlying asset when the futures contract expires. The seller of a futures contract is taking on the obligation to provide the underlying asset at the expiration date.
- Options: These are contracts that give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a set price within a specific time period. The seller, who is also called the writer, has the obligation to sell the asset (if a call option) or to buy the asset (if a put option) if the option is exercised by the buyer.
Derivatives can be traded on an exchange (exchange-traded derivatives) or over-the-counter (OTC), which means the trade is made directly between two parties, without going through an exchange.
In the world of cryptocurrencies, derivatives work in much the same way, though the underlying asset is a digital asset such as Bitcoin, Ethereum, etc. Crypto derivatives include futures and options for different cryptocurrencies. These financial instruments provide a way for traders to speculate on the future price movements of cryptocurrencies and to hedge their digital asset portfolios against potential losses.