EMX Trading Series: Spot vs. Derivatives

Posted by EMX Team on Aug 15, 2019 1:47:48 PM

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This is the first post in a series of blog posts and videos about trading strategies. In this content series, you’ll learn about a variety of trading techniques, methods, and models. With a better understanding of the types of strategies available you can make well-informed decisions to level up your portfolio on EMX.

You’ve probably heard the term “spot” used to describe an exchange - or a contract on an exchange. What is a spot market and how does it differ from a derivatives market? Further confusing things, some spot exchanges offer margin trading. Is trading on margin on a spot exchange the same as trading with leverage on a derivatives exchange? Well, no. The distinctions are clear, but the terms can be confusing. I’ll explain them all here.

Spot Market vs. Derivative Market

When you deposit BTC to Binance and buy ETH/BTC, you’re trading spot BTC/ETH. You’re exchanging your BTC for ETH with instant delivery. You can now withdraw that ETH (and whatever BTC is leftover) and it’s yours. A spot exchange is an exchange that offers token pairs with instant delivery. Binance and Coinbase are spot exchanges.

Let’s say instead that you deposit BTC to EMX and go long a few contracts of ETH-PERP. (Going “long” ETH-PERP is the same concept as “buying”, but long/short are terms more commonly used with derivatives.) The same amount of BTC as you deposited (minus transaction fees) is still there in your EMX wallet, and now you have exposure to ETH. What do I mean by “exposure” and how is trading ETH-PERP on EMX different from buying ETH/BTC on Binance? Read on.

Exposure

Exposure is the total amount of risk you have in a particular asset. If you have 1 ETH on your Ledger, you have 1 ETH exposure (or $210 USD exposure- or whatever the ETH/USD price is at the time). Now, let’s say you send some BTC to EMX and go short 1 contract of ETH-PERP.  You now have -1 ETH exposure on EMX (even though you don’t hold any actual ETH in your EMX wallet, only BTC). Here's the cool thing about this setup- your net ETH exposure is zero. If the price of ETH goes up or down, you don’t care because your ETH exposure is 100% "hedged" (a concept we’ll describe in-detail later). Plus, you’re still holding your ETH on your Ledger!

You might be asking- if I’m not really holding ETH on EMX and only a position in a derivative (in this case, a perpetual swap named ETH-PERP), what ensures that the price of ETH-PERP tracks the true price of ETH? Well, derivatives are designed to track an underlying price index with varying mechanisms depending on the type of derivative. In the case of ETH-PERP, that underlying index is a combination of spot market ETH/USD prices. The mechanism that causes ETH-PERP to track spot ETH/USD is the perpetual swap "funding" system. On EMX, we offer both perpetual swaps and futures and they use different mechanisms to track underlying spot market prices. We’ll explain how this works in our next post in the series.

Back to the original question- "What’s different about buying ETH/BTC on Binance than going long ETH-PERP on EMX?" Well, as we’ve seen, in exposure or risk terms, they’re the same (or at least very similar- we’ll describe a few differences later). But, what about that BTC in your EMX account? What is it being used for? Well, it’s collateralizing your long position in ETH-PERP. In other words, it’s being used to cover the initial margin requirement of your current position in derivatives on EMX. Thus it is enabling your use of leverage. You can post $100 in BTC to EMX and take a $1,000 position in ETH-PERP, for example. Let’s quickly explain margin trading (and clear up how it differs from "margin" offered by some spot exchanges.

Margin Trading

Margin trading (or trading on margin) can mean two related things:

On a derivatives exchange (like EMX), margin trading can mean using one collateral currency (say BTC) to cover some or all of the risk of a derivatives position. For example, if you post 1 BTC and take a long position in ETH-PERP and ETH drops in price, you lose some of the BTC. If ETH drops too far, you might lose most or all of your BTC (and be liquidated). You never actually held any ETH. You’re not borrowing currency, you’re effectively paying a down payment (or “initial margin”) on your positions, but not necessarily the whole position size. If you’re trading with 10x leverage for example, you’re paying 1/10 of the exposure of your position - and if you close your position, that payment is refunded. On a derivatives exchange, you don’t really “pay” the initial margin, it’s simply locked up (non-withdrawable) while you hold your position. If your position loses money, this is where that money comes from to pay the winner "on the other side" of that trade.

On a spot exchange, margin trading can allow you to do a similar thing (trade with leverage by only covering part of your exposure), but there is an explicit borrow or loan in place - and there is an interest rate that comes with that borrow. This explicit loan is necessary as tokens are exchanged instantly on a spot exchange (BTC for ETH, for example) and the full amount of currency needs to be there for the trader on the other side of the transaction to have access to immediately withdraw if they’d like. Due to the need to explicitly borrow currency to cover a leveraged position, leverage amounts are generally much lower when margin trading on a spot exchange (~3x) than on a derivatives exchange (up to 100x). There’s also the complexity of dealing with interest payments.

So, in summary - margin trading means trading with leverage - but the mechanism for how that happens is different between spot (explicit loan) and derivatives (initial margin, “down payment”) exchanges.

When should I trade spot and when should I trade derivatives?

There are very good reasons to trade both spot and derivatives - even at the same time! You may want to trade spot to gain access to the benefits of holding a token (like staking or voting) or if you want to transfer tokens to a hardware wallet for long-term storage. On the other hand, derivatives are excellent instruments for quick and cheap exposure to a huge range of markets all on one exchange and without having to deal with the complexities of each blockchain (paying gas on ETH transactions or downloading an EOS wallet, for example).

In conclusion, let’s say you send 1 BTC to EMX and take long or short positions on ETH, Tezos, Gold, or the Euro. You do so while continuing to hold your BTC. If you exit your positions, or make money on your positions, you can withdraw that BTC right back to your wallet. It's that easy.

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Now put this newfound education to work, and trade derivatives on EMX, with up to 40x leverage. Sign up today at trade.emx.com.

Topics: EMX Team