Derivative definition: A financial contract valued from an underlying asset, allowing investors to speculate on price movements without owning the actual asset.

In traditional finance, a derivative is a contract linked to the performance of another asset, whether that's an asset, an index, or an interest rate. This "underlying" forms the basis of the derivative's value. With reference to cryptocurrencies, the idea of a derivative translates similarly, with the principal difference being that the underlying is typically a cryptocurrency, such as Bitcoin or Ethereum.

Cryptocurrency derivatives empower investors to tap into the price movements of crypto assets without needing to hold the cryptocurrency itself. This financial tool offers a pathway to hedge, speculate, and maneuver the crypto market's notorious volatility, potentially leading to either magnified gains or losses.

Different versions of cryptocurrency derivatives have been brought to the market: Futures Contracts, Options Contracts, Swaps, and Perpetual Contracts.

Futures Contracts refer to an agreement to purchase or offload the underlying cryptocurrency at a fixed price on a designated future date. Depending on the contract's stipulations, futures can culminate in either a cash settlement or a physical delivery of the cryptocurrency.

Options Contracts stand out by giving the holder a right, devoid of any obligation, to buy (known as a call option) or sell (termed as a put option) a specified amount of the underlying cryptocurrency at an agreed-upon price within a determined timeframe. As a counteraction, the option's seller garners a premium from its buyer.

Swaps involve a mutual agreement where two parties consent to exchange sequences of cash flows over a delineated duration. These are frequently employed to tweak the nature of an investment without resorting to liquidation.

Perpetual Contracts are a specialized breed of futures contracts devoid of a set expiration date. They are tailored to closely emulate the spot market price and find common use in short-term trading strategies.

Cryptocurrency has grown in popularity for many reasons. Leverage is a notable one, allowing traders to initiate positions that overshadow their tangible capital. This leverage, while amplifying potential gains, can also compound losses. Hedging is another draw, offering investors a safety net against potential adverse price shifts in their cryptocurrency assets. Moreover, for conventional investors, the allure lies in the opportunity to step into the crypto market without navigating the intricacies of procuring, storing, and securing the actual cryptocurrencies. Lastly, with the maturation of derivatives markets, they have cemented their role in price discovery, aiding in the prognostication of future cryptocurrency prices.

Yet, as with many financial tools, derivatives are not devoid of risks. Their complex design, combined with the unpredictable world of cryptocurrency, can lead to large losses, especially for beginners. It's essential to understand these tools fully before trading.

Regulation, too, poses an evolving challenge. The crypto world is quickly changing, and many regions still have uncertain regulatory positions. These changing regulations directly impact how crypto derivatives function and their accessibility.

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Michelle Legge
By Michelle LeggeHead of Crypto Tax Education
Updated Nov 9, 2023
This article has been fact checked and reviewed as per our editorial policy.