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What are derivatives?

Derivatives are tradable securities or contracts that derive their value from an underlying asset. Derivatives are sophisticated, generally high-risk financial instruments that are useful for managing risk via hedging.

In the case of cryptocurrency derivatives, the underlying assets, in most cases, are BTC or other top cryptocurrencies.

There are three main types of cryptocurrency derivatives: futures, options and perpetual swaps.

A futures contract is an agreement between two parties — generally two users on an exchange — to buy and sell an underlying asset at an agreed-upon price (the forward price), at a certain date in the future. There are two types of cryptocurrency futures, either cash-settled or physically settled.

For cash-settled cryptocurrency futures, most exchanges do not require futures contract holders to receive cryptocurrencies once the contract expires. For physically settled futures, such as BTC, actual Bitcoins are used as settlements once the contract expires.

For cryptocurrency options, holders purchase the “option” or right to buy or sell the cryptocurrency at a set price in the future. If the holder decides not to exercise their right to buy or sell on the expiry date, the contract simply lapses. In this case, holders lose the premium — i.e., the price they paid for the contract.

Perpetual swaps are futures contracts without an expiry date. Because there is no settlement date, neither of the parties has to buy or sell. Perpetual swaps use funding rates to keep the price of a contract in line with the underlying asset’s spot price, discouraging major deviations.