Crypto Derivatives vs. Cryptocurrencies – Understanding Their Differences
Traditional cryptocurrencies are an excellent way to get started with owning digital assets. However, with time and evolution in the blockchain ecosystem and crypto market, new financial instruments became popularized within the market. One such tool is a crypto derivative.
Typically, one can trade cryptocurrencies on either a spot market or a derivate one. While they both have the potential to earn a sizable profit, there are significant differences between them. This article explores the differences between derivatives crypto and cryptocurrencies in detail so that you can decide which one is more suitable for your trading profile.
Spot vs. derivatives market
- The fundamental difference between spot and derivatives markets is that the traders buy and sell actual crypto tokens on the spot and crypto derivatives such as smart contracts on a derivatives market.
- However, in both marketplaces, a trader can utilize the same cryptocurrency to achieve financial success by trading various securities.
Cryptocurrencies
Cryptocurrencies are digital assets that one can buy in a particular amount to start trading on a spot market. After purchasing crypto, one needs to deposit the coins into the trading account on the exchange to start the transaction.
How cryptocurrency trading works in Spot Exchange
Actual digital crypto tokens get traded on spot exchanges where one currency is converted immediately after the successful validation of the transaction in the blockchain. Information regarding the transaction is stored permanently on the blockchain’s ledger.
Crypto derivatives
A crypto derivative derives its value from an underlying asset (often a crypto token). Derivatives, unlike cryptocurrencies, are not actual digital assets. They work in the form of contracts that enable traders to speculate on the underlying asset’s price without owing it.
There are various types of crypto derivatives, each with its unique features.
- Options
- Futures
- Swaps
- Forwards
- Perpetual contracts
How Crypto derivatives Work
Like every trade, derivatives involve a buyer and a seller. Both parties decide to settle the pledges under the contract’s agreement and exchange cash.
- Thus, the derivatives trade is settled by a cash settlement in the future, and not by the underlying asset’s delivery. The price changes of the contract depend on the price fluctuations of the underlying crypto.
- Interestingly, each transaction in derivatives has the same financial effect as a spot market.
Differences between Cryptocurrencies and Crypto Derivatives
Now, we shall see why trading in crypto derivatives is more beneficial than digital cryptocurrencies.
1. Owning actual crypto: In a spot market, you can hold a particular amount of crypto in your wallet. But while working with a smart contract, you can access the crypto as an underlying asset without even possessing it.
2. Trading eligibility: In a spot exchange, you must purchase digital currency to start trading. You can’t enter the trade without owning a particular amount of crypto in your crypto wallet. Contrary-wise, the derivatives get designed in the form of contracts allowing you to speculate on a crypto’s price without investing in the crypto outright.
3. Liquidity: Spot markets have less liquidity in comparison to the derivatives market. Essentially a lower liquidity results in lower trading volume and higher bid-ask spreads that leads to less profitability. Due to fast execution speed and ultra-low spreads, crypto derivatives have established themselves as a profitable trading option. These instruments offer superior liquidity and higher trading volume compared to any other crypto platform in the world.
4. Selling short: A significant disadvantage of spot markets is that active traders can not sell short on the platform. Conversely, derivatives lets you sell short effortlessly, an essential feature for every active trader.
5. Leverage: Although the borrowing cost may be high depending on the market situation and crypto’s price, leverage on the spot market is nearly absent or very low. But a crypto derivatives market provides high leverage up to 50:1, meaning the trader can enter with a margin of 1/50th of the trade size.
6. Risk-management: Additionally, using the exchange’s central clearing feature derivatives protect counter-party risk.
Final Thoughts
Today, investors are becoming increasingly inclined to invest their time and resources in derivatives as they make risk management a breeze. Moreover, one can enter the trade with less capital and lower cost, whereas going short is effortless. Also, the market’s liquidity makes it attractive to traders as they can earn more profit in a shorter period of time.
