Everything you need to know about Bitcoin derivatives

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Even with Bitcoin notorious volatility, to some speculators, it is still not enough to fuel their risk appetite. Which is why many are turning towards Bitcoin derivatives. Leveraged products that can turn even minor price swings into major gains. According to a recent article by Bloomberg, global trading of derivatives is outpacing that of spot trading in Bitcoin.

Derivate trading trends

Global daily trading volume in Bitcoin derivatives is now in the range of $5 billion to $10 billion, 10 to 18 times higher than Bitcoin spot volume. “That’s where the money is to be made in crypto,” Sid Shekhar, co-founder of London-based tracker TokenAnalyst, told Bloomberg. “It’s the biggest casino ever.” Traders looking for windfall profits that come from taking more risks are migrating to derivatives markets, making use of leverage to increase the potential gains in the absence of volatile price movements of the underlying asset. Both BitMex and Binance offer Bitcoin futures contracts that can be leveraged more than 100 times and often with no expiry date (i.e. perpetual futures contracts). Binance just launched its futures in September 2019 and is already handling $500 million in futures every day. Perhaps, one of the most attractive aspects of derivatives trading is the fact that you do not have to lock up as much capital as when trading spot. “When trading with leverage, traders don’t have to tie up as much capital as you would trading spot,” Binance CEO Zhao Changpeng told Bloomberg. “This makes trading futures cheaper. This is the reason why futures trading in traditional markets is higher than spot trading.”

There is a consensus that for every winner, there will be a loser, and hence winners get paid by the losing parties, and as such the derivatives exchanges themselves are operating at risk-free profits. That is not true. When trading on leverage, funds are borrowed from the exchanges themselves, allowing traders to trade large position sizing with smaller capital, and in extreme volatility, where trades get stop out with slippages, the losses are absorbed by the exchanges themselves, and this is why insurance funds were created.

1) Exchanges are protected by liquidation engines

High leverages orders usually end up bankrupt in volatile markets, any positions with leverage of 20x and above must be forcefully liquidated after a 4.8% move. Exchanges have liquidation engines that will close a client’s bankrupt position by executing an inverse order in the market. The liquidation engine aims to close the trader’s position at a price favorable enough that not all the remaining margin gets used. If it manages to do so, the profits will go to the insurance fund, else funds get withdrawn from that insurance fund. The second feature of a liquidation engine is auto-deleveraging. If the liquidation engine cannot close liquidated positions profitably, and the insurance funds run low, it will take money from traders with winning positions to cover losses from losing positions.

2) Avoid liquidation engines

The most important rule for traders trading in derivatives is to manually set stop losses, this is so that the liquidation engines will not activate. Most exchanges provide an estimated liquidation price for each position so it is not a difficult thing to do.

3) Managing size

Using excessive leverage when trading futures contracts is exposing your capital to unnecessary risk and some exchanges manage liquidations very aggressively. To prevent this scenario, one can actively manage the position and its stop-loss orders. For some, speculation is tantamount to gambling. And while leverage, using borrowed cash to increase one’s exposure in a financial asset, can amplify gains, it can also amplify losses.

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