With an ongoing heated bull market, you’ve likely heard about leverage and derivative markets but may be lost on what they actually are. Derivative markets allow traders to trade a secondary contract that derives its value from the underlying asset. For many traders, the volatility involved in crypto excites them, and they want to capitalize on the ebbs and flows of the market. So who trades these markets?
Well, a lot of people who accept cryptocurrencies as payment, and a lot of bitcoin mining firms would like to hedge positions they have. If you are collecting a lot of bitcoin, but the price is going down, you are losing money, but trading short crypto derivative positions allows them to hedge these positions and keep steadier, guaranteed profit numbers.
How futures markets work, a form of derivative trading is that you make a contract with someone that you will sell x amount of Bitcoin on a certain date, at a certain price. This is very handy for bitcoin miners, as it provides them with certainty as there is a binding obligation to carry forward with the deal. It also allows them to hedge their assets and holdings accordingly.
As for options contracts, it is less of a guarantee, but it gives buyers and sellers the right to execute a contract at a certain date. For example, if I wanted insurance against my positions, and I am a bitcoin mining company. I can use leverage on my option contract to buy a contract for very cheap, and for each dollar, the market moves against your large position, you are protected from leverage.
You can leverage positions from anywhere to 2 times to 100 times your position, but also consider that you will be liquidated if the price goes the wrong way. But people who deal with these markets as a hedge against current positions do not mind this, for their large holdings go up and equal out whatever they are losing on getting liquidated.
We’ve seen derivatives markets and leverage really boom with this bull run. Of course, some of these market participants are described above as people hedging their bets. But the other side of it is retail traders trying to make a quick buck. Some people feel they can analyze market trends through technical analysis or identifying chart patterns that are more likely to result in a move to the upside or the downside.
People generally do this when they have a strong conviction about the next move a cryptocurrency will make so that they can maximize profits on a small investment. Of course, this all leaves small and inexperienced traders vulnerable to liquidation and feel a lot of pain when trades go against them, and they lose 100% of their initial investment.
This can impact entire crypto markets when many small leveraged traders pile into positions that can be super volatile, drastic price movements. The initial run from 20k to 65k was largely due to this, and along the way, we saw multiple 40% pullbacks. A 10% pullback can trigger liquidations, which causes more selling, and markets spiral downwards until leverage exists in the system. Generally, this would be a good time to place a spot buy, as there may actually be a limited downside.
Luckily, we are starting to see leverage get sucked out of the system, and part of this is crypto derivatives exchanges like FTX are limited leverage. Instead of 100x longs, many are now limited to 25x longs, which can cause dips to be shallower and shorter, which is healthier for the entire market.