An Introduction to Synthetic Derivatives in Crypto

Trading can be more than just buying and selling an asset. With buying spot one can only profit from rising prizes. However synthetic derivatives also allow to “short sell”, i.e. bet on falling prizes. So one can profit while the prizes go down. They also allow trading on margin. This article is an introduction to synthetic derivatives in crypto and defines some terms around them.

Futures

A future is a contract that is settled at a certain time – in the future, thus the name. Usually there is a reference price or index used for the settlement. The future contract might trade above or below but at the end it is settled at reference price. If a contract trades above reference it is called in “contango”. So if this contract is 5% in contango when the contract runs out it will settle at 5% below the price it was traded in. And vice versa if it trades below, which is called in “backwardation”. Usually you can long and short these contracts, meaning “betting” that the price will go up or down.

The BitMex XBTZ18 december futures contract. The blue line represents the the reference price. This contract is trading in backwardation. When the contract runs out it will settle at the price of the blue line.

Swaps

There is a different kind of contract called swap or perpetual swap. Perpetual means it is never settled but goes on and on. Shorts are “swapped” for longs and vice versa. The most famous exchange that offers these kinds of derivatives for crypto at the moment is BitMex (short for “Bitcoin Mercantile Exchange”). But it is not only famous, it is also notorios for its “dropouts” when price becomes very volatile, the dreaded “order submission errrors”. So a trader can’t place any orders when there is high volatility. That made a lot of people lose a lot of money and got them looking for alternatives. Direct competitors are deribit (Short for “Derivative” and “Bitcoin”) or OKEx. Some exchanges like Bitfinex or Kraken offer margin trading, too, but usually only with smaller leverage (i.e. x3.33).

The dreaded BitMex “Order Submission Error”

Margin and Leverage

Usually one can trade those contracts on “margin”. Meaning you borrow money from other traders to multiply your gains – or your losses. With this you can “leverage” your trades. Some crypto exchanges that offer margin trading allow up to x100 leverage. The amount you put down for trading is the margin. Let’s say you trade $1000 with 10 times leverage. So you only have to put down $100 margin. All your gains are multiplied by ten. But also your losses. So if price goes down 10% you are at a 100% loss – meaning your position gets liquidated and your margin is used to pay back the people who funded you – so it’s gone.

The BitMex leverage interface

Funding

How does this funding work? In the perpetual swaps the longs fund the shorts or the shorts fund the longs, depending on the price action. If the price goes up very fast the funding will be in favor of the shorts, because more people are longing than shorting. And so the funding offers an incentive for people to short. On Bitmex this funding system works for swaps. The futures work with a premium. That means you have to pay a premium if price moves against you.

These differences between the derivatives allow different kinds of arbitrage, so one can make money without the price moving and with less risk than just trading. Lets say the longs fund the shorts. So the trader shorts the swaps to collect the funding . To reduce his risk he longs the futures with the same amount of money. This is called hedging. So he gets paid every eight hours without being touched by prize action. If you are in a trade and there is a sharp move and you expect a retracement it sometimes makes sense to not close the trade, but to hedge it as described, to collect funding. On BitMex it usually varies from about 0,01% to 0,1% – every eight hours.

In this case longs fund shorts with 0,1155% every 8 hours. Picture from the BitMex-interface

Warning

Be warned: if you are a fresh trader and want to try margin trading: If you use high leverage you can blow your paycheck in a matter of seconds. You play the hardest game in the world against the best players which have more information than you and unlimited money to manipulate the price in any direction they please. Only a small percentage of people make money margin trading, the others get eaten alive.

If however you make it to the point where you are profitable it can become quite lucrative.

 

 

 

This article was written by the Hochfrequenz-Tulpentradingbot

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