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A Look at the Bitcoin Derivatives Markets

On October 31, Morgan Stanley released a report describing Bitcoin as a new institutional investment asset class. This statement recognizes the crypto market for its many opportunities to profit including margin trading and leveraging. The crypto market is quickly expanding from a buy, sell, and own exchanges, to a full securities trading marketplace. Bitcoin’s profit generating potential caught the attention of elite traders and market makers. As a result margin trading is becoming a new financial dimension within the crypto space.

Margin trading

These are trading methods that involve borrowing money from users or brokers in an exchange and using it to buy crypto curremcies. Loans are secured through a contract whose terms are based on leverage.  And the purchased crypto currency serves as collateral. In other words, investors can take a loan and leverage it up to 500 times the amount borrowed using derivatives. The derivatives can be bet in favor or against the performance of Bitcoin or other cryptocurrency. If successful, the investor can multiply his gains exponentially, making margin trading undeniably attractive to experienced traders.

Large banks adamantly oppose accepting Bitcoin as a digital currency but acknowledge the market’s potential to generate massive profits through trading fees. And that is precisely why Bitcoin derivatives exist and new crypto exchanges are emerging to capitalize on the demand. For exchanges, the fees generated from transactions and loan interests are far too good to ignore. And for investors, derivatives offer profits many times larger than just owning and holding crypto.

Derivatives

According to Wikipedia, “In finance, a derivative is a contract that derives its value from the performance of an underlying entity.” In most cases a Stock.

Despite the many stern warnings from the SEC many exchanges continue to skirt the line and push the limits on they can get away with. In the US, crypto margin, or fractional/leverage trading is not legal. It is not compliant with US securities laws. And some exchanges like 1Broker and EtherDelta have recently gotten in trouble for making it accessible to US investors. But once again, the money is worth the risk.  There are several types of Bitcoin derivatives in  margin trading.

Options

Bitcoin’s price volatility makes “Options” an attractive trading choice. Ally Bank describes an option as “a contract that gives a buyer the right to buy or sell an asset at a fixed price for a specific amount of time.” A “Call” option is a bet predicting the future price of an asset. And a “Put” option is betting that the price will decline (short). Options trading require investors to estimate whether Bitcoin’s value will go up or down, by how much, and when. Several crypto exchanges offer Options trading (Deribit, Spectre, Quedex, etc).

Futures

These are contracts that function in a similar way as options. They allow investors to buy contracts, high (long) or low (short) for the price of Bitcoin to be at a future date. If the price of Bitcoin matches the price established in the contract at the expiration date, the exchange settles the contract in cash. Futures contracts incidentally serve a price stabilization tool for an asset by betting against its price. In essence, the profitability of Futures prevents prices from skyrocketing. Exchanges like CBOE, CME, Bitmex, Poloniex, and others offer futures contracts. Unlike margin trading, Futures contracts are legal in the US because the CFTC observes Bitcoin as a commodity and not a security.

Alternatives

Other alternate trading derivatives exist which are comparable to Options and Futures. For example, Prediction markets are a relatively new way to margin trade by predicting future values in percentages. Like Futures, they use contracts to establish a bet on future performance of crypto currencies. These contracts are served through Predictious.com. Banks continue to develop variations of derivatives to bring into the crypto market. Among these Citigroup plans to offer digital asset receipts, Goldman Sachs’ non-deliverable forwards, and Morgan Stanley’s price return swaps.

Analysis

The Bitcoin derivatives market serves risk-tolerant investors that seek to bet against the price of Bitcoin. However, to succeed, investors must posess a deep understanding of trading practices, strategies, and market movements. Furthermore, they must calculate with precision how markets behave, and accurately predict its future direction.

With its $13 billion daily trading volume, the crypto market is too temptimg a target for traders to resist. However, it is important to mention that the costs of margin trading are extremely high. They vary from 0 to .40% of the transaction, plus fees for opening, maintaining, and closing the position.

The SEC is working to define a legal framework for crypto currencies as well as approval of a Bitcoin ETF. Until then, only international traders will benefit from margin trading Bitcoin.

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