Derivatives

Derivatives are financial contracts whose value depends on something else, such as crypto. You don't buy the crypto itself; instead, you trade an agreement based on its price.

What are derivatives?

The asset whose price a contract tracks is called the underlying asset. In crypto, this could be Bitcoin, for example. If Bitcoin's price rises or falls, the value of the contract usually changes too.

Derivatives can be used to reduce the risk of price changes. They're also used to speculate on whether a price will rise or fall. Common types include futures and options.

These contracts can be traded on a crypto exchange, but sometimes two parties make an agreement directly. With a direct agreement, there's a risk that the other party won't meet its obligations.

An example of a derivative

Suppose you think the price of Bitcoin will rise, but you don't buy any Bitcoin. Instead, you enter into a contract whose value moves with the price of Bitcoin.

If the price rises as you expect, the contract may become more valuable. If the price falls, you could lose money. The contract is the derivative; Bitcoin is the underlying asset.

Why are derivatives important in crypto?

In crypto news, derivatives often refer to futures, long and short positions, or leverage. Leverage means taking a larger position with a smaller amount of money upfront. This can increase profits, but it can also increase losses. You could even lose your entire investment.

Derivatives can show what traders think about possible price movements. That doesn't mean they can accurately predict future prices. These are complex products, and their value can be hard to determine.

When you use a derivative, you usually don't automatically own the underlying crypto. So a contract based on Bitcoin is different from buying and holding Bitcoin.