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The crypto community is somewhat obsessed with leverage trading, taking huge bets with high leverage on the smallest of moves by Bitcoin and other assets. The recent chop has wiped out a lot of unsuspecting positions minimizing profits at a time where making money should be protected. This begs the question of why derivate contracts exist, what their intended purpose is, and how they should properly be utilized.
The primary purpose behind derivative contracts is the transfer of risk without the need to trade the underlying asset. This allows for more effective risk management. In addition, the derivatives market plays a role in information discovery and market efficiency.
The futures market aids in price discovery. Futures prices can be thought of as a forecast of future spot prices, but in reality, they only provide a little more information than the spot price. However, they do so in an efficient manner. A futures price also provides an indication of what price would be acceptable to avoid uncertainty. This can help to reduce volatility as traders can see the theoretical fair price of an asset in advance and bet accordingly.
In the case of options, one of the characteristics of the asset underlying the option is volatility and by using option pricing models, the volatility of the underlying asset can be determined. This is the volatility implied by the price of the option. The level of implied volatility is a good measure of general uncertainty in the market or a measure of fear.
There are also some operational advantages to the derivative market:
- Derivatives have lower transaction costs than transacting in the equivalent underlying asset.
- Derivatives markets typically have greater liquidity than the underlying market.
- Derivatives allow short positions to be entered into easily.
Markets can be thought of as reasonably efficient. When prices do deviate from fundamental values, the derivatives market offers a low-cost way to exploit the mispricing. Less capital is required, transaction costs are lower, and shorting is made possible.
Investors are also far more willing to trade if they know they can manage their risks. This increased willingness to trade increases the number of market participants which increases market liquidity.
Why does this matter?
Because most retail traders use options and derivatives to speculate with too much leverage on the short-term price action of an asset. That is not the intended purpose.
Options and derivatives are meant to be used as a risk management tool - a way to hedge against a larger spot position with lower fees, less risk, and more flexibility.
If I short an asset, I generally make far more money being wrong than being right, because I am shorting against something that I hold a large quantity of in the spot market.
Right now, if you just hold spot crypto, it’s really hard to fail, I personally don’t see much of a use in these contracts unless you are unsatisfied with the returns the market is offering or you are looking to hedge. Understand the purpose of the products you are trading and use them accordingly.
In This Issue:
- The Purpose Of Derivatives
- Bitcoin Thoughts And Analysis
- Justin Sun Launching Algorithmic Stablecoin
- Itheum Launching On Maiar
- My Recommended Platforms And Tools
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