The financial market can be a very complex environment, especially for those taking their first steps as an investor.

In addition to all the existing theory, there is still a need for practical experience, requiring caution and risk management, because in the same way that it is possible to make a lot of money, it is very easy to lose it.

Therefore, for an investor's journey to be healthy and successful, it takes a lot of study and feet on the ground. The process is not so fast, but it is rewarding when the first results start to appear.

Aiming to contribute to its history as an investor, it has brought a glossary with the main terms used in the derivatives market, a financial tool increasingly known by crypto investors that will help you better understand how this type of asset works.

What are derivatives?

These are financial instruments that derive their price from an underlying asset, for example: stocks, interest rates, currencies, crypto-assets and commodities (such as gold and oil).

The dynamics of derivatives occurs with trading between two parties, where one party sells the risk of an asset and the other buys it, hoping to profit from it. This is done through contracts, with pre-established values and deadlines.

Derivatives were widely used in the commodities market, but today they have gained a presence in other types of markets.

What are derivatives for?

Derivatives have different characteristics and forms of application, the two main ones being for hedging and speculation.

Let's understand each of them better!

Arbitrage

The main objective of an arbitrageur using derivatives is to exploit price differentials in different markets. He therefore buys an asset at a cheaper rate in one market and sells it at a higher rate in another. This results in a low risk profit opportunity.

However, these windows of opportunity are not so frequent and, when they do appear, they tend to last a short time.

For example, let's say Bitcoin is trading at $22,000 on the spot market and simultaneously quoted at $22,500 on the futures market, on a contract expiring in 1 month. The arbitrageur can then buy 1 BTC on the spot market and then sell 1 BTC on the futures market, guaranteeing a profit of $500.00.

Hedge (Financial protection)

Here we will use as an example a classic way of using derivatives as a hedge.

A soy producer will harvest and sell his production in 5 months. Currently, a kilo of soy is sold at R$80.00, but he does not want to run the risk of having to sell it for a lower price when the soy is ready to be sold, after all it is a commodity and they tend to fluctuate a lot in price.

In order not to run the risk of having to sell his production at a lower price than the current price, he then resorts to the derivatives market, purchasing soybean futures contracts. Through this contract, the producer sells his crop at a price previously agreed with the buyer, and thus locks in his profit. If, at the time of harvest, the price of a kilo of soybeans is lower, say R$50, or higher, than R$100, it does not matter, the profit from the sale is already guaranteed and on the expiration day the producer will receive the amount previously agreed in the contract.

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Speculation

Let's think about the person who purchased the soybean contract for R$80.00. She believes (that is, speculates) that in 5 months, the kilo of soy will be more expensive. If this happens, it will be able to sell that kilo of soy for a higher price and thus make a profit from this contract. It gains from the small bid and ask price differentials of each contract.

In the crypto market, a speculator can sell perpetual futures contracts if he wants to speculate that the price of BTC will fall.

Now that we know what derivatives are for, let's know what types they are subdivided into.

Futures Contracts

These contracts represent an agreement between two parties - to buy or sell an asset (Bitcoin, for example) - at a predetermined date and future price. The BTC futures contract derives its value from Bitcoin, thus the price moves in sync with the Bitcoin price.

They allow investors to gain exposure to Bitcoin without buying it. In short, futures contracts allow the investor to bet on the price trajectory of an underlying asset.

In the crypto market, there are both futures contracts with expiry dates that are then settled, and contracts with no maturity, called perpetuals, which do not have a settlement period.

Options

They are derivatives that give the investor the right to buy or sell an asset at a certain price (strike price) on a specific date (expiration date).

The person who buys an option is known as the holder. He has the right (but not the obligation) to exercise the option – buy or sell the asset on the expiration date – at the agreed price. He can simply choose to let the option expire and only lose the amount paid for the option, better known as the premium.

On the other hand, the seller of an option (also called the writer) has the obligation to exercise the contract, if the buyer wishes to perform it.

For example, if on the expiration day the holder of a call option of 1 BTC wants to exercise his right, the writer will be obliged to have the BTC to sell to him.

Let's reinforce this concept by understanding the two main types of options:

CALL

A call option gives its holder (holder) the right, but not the obligation, to purchase an asset at a previously agreed strike price on a specified expiration date.

Example: Bob bought a call option on Bitcoin at $23,000, expiring on September 9. For this, Bob paid the option writer a premium, say $200, to be entitled to buy the BTC within the agreed time frame.

On the day the option expires, Bob will have the possibility to choose whether to buy BTC. If on the expiration day the price of BTC is higher than $23,000, he can exercise the option and buy 1 BTC for $23,000.

On the other hand, if 1 BTC is priced at $22,000, Bob will not need to exercise the right and will only have lost the $200 premium, as it will be more worthwhile to acquire the BTC directly on the spot market.

PUT

A PUT gives the investor the possibility to profit in a scenario of falling price of an asset. Anyone who buys a PUT has the right to sell an asset at a pre-established price.

For example: if Bob believes in the drop in the price of Bitcoin, which is now worth US$22,000, he can acquire a PUT of 1 BTC and thus have the right to sell 1 BTC at US$22,000.

If on the expiration date 1 BTC is worth $19,000, he can buy BTC on the spot market cheaper and exercise the put option, selling 1 BTC at $22,000.

On the other hand, if 1 BTC is quoted at US$24,000 on the expiry day, it is not worth exercising the right to sell at US$22,000, as it will be selling below the current price.

In the case of both PUT and CALL, the investor pays the “premium” to the option writer, in order to have the right to buy or sell the asset.

This premium is the remuneration of the option writer and is the maximum loss incurred by the investor who purchases the option. Therefore, this type of option is also called dust because if the investor does not exercise the right at maturity, it turns to dust and the investor only loses what he paid in the “premium”.

Forward contracts

In this type of contract, a buyer and a seller agree to buy and sell an asset at a fixed price.

For example, for a forward contract, an investor can commit to buy 1 Bitcoin forward for 60 days, for $22,500. On the expiration date, the seller will be obliged to deliver the BTC at the agreed price. If on the expiration date the price of BTC is higher, the buyer will have bought BTC at a lower price, whereas the seller will have to sell BTC at a lower price than the current one.

This type of contract has less liquidity and is more used in the traditional financial market than in cryptocurrencies.

Swaps

A swap contract is an agreement in which two investors negotiate the exchange of profitability between two assets. In practice, they exchange cash flows with each other, taking as a starting point the profitability of one of the assets compared to the other. The objective is to reduce risks and increase predictability for those involved in the operation.

Swaps are not traded on exchanges and retail investors generally do not use them. Swaps are over-the-counter (OTC) contracts, carried out mainly between companies or financial institutions.

If an exporting company has to make a future payment of an amount in dollars, for example, it can use a swap operation. Therefore, the company guarantees that it will pay the agreed amount, thus canceling the exchange rate risk, that is, a rise in the dollar.

These contracts are mostly used by exporting companies, which have revenues in foreign currencies and costs in reais. As the exchange rate fluctuates, the swap helps to provide greater predictability for the company.

The derivatives market in July

The crypto derivatives market has gained increasing prominence among investors and volume.

In July, the trading value of cryptocurrency derivative contracts rose 13.4% from June, the first increase since March.

Futures traded $3.17 trillion, against a 1.34% drop in spot (or spot) market volume, which traded $1.39 trillion, the lowest level since December 2020.

On Coinbase, for example, spot trading volume dropped 12.8% to $51.5 billion.

An interesting difference that we can highlight between these two markets is that derivatives contracts represent the speculative appetite of the market for offering leverage, while the spot market is seen as preferred by long-term investors.

Volume of Crypto Derivatives vs. spot

Derivatives volumes increased 13.4% in July to $3.17 trillion. Meanwhile, spot volume declined 1.34% to $1.39 trillion. The derivatives market now accounts for 69.1% of total market trading versus 66.1% in June.

Exchanges with the highest volumes

Binance leads the crypto derivatives market with 64.1% ($2 trillion) of total trading volume in July, up 28.2% since June. Next comes OKX, with 15.3% market share (US$478 billion) and Bybit, with 9.90% market share (US$309 billion).

Trading volume on the CME

On the CME, a traditional American market derivatives exchange, 235,730 BTC futures contracts were traded in July, down 7.11% compared to June. This was the first recorded decline in the number of BTC futures contracts traded on the CME in four months.

Despite having emerged to mitigate the risks of commodity producers, derivatives have evolved a lot and are now widely used in the financial market, including cryptoassets.

However, using these instruments requires a lot of attention and experience, as it is very easy to lose money with them. On the other hand, if used well, they can be a great help for investors to protect their portfolio.

In closing, I leave you with a reflection, a quote from a great investor:

“Investing should be more like watching paint dry or watching grass grow. If you want adrenaline, take $800 and go to Vegas.” - Paul Samuelson

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