EMX Trading Series: Types of Derivatives

Posted by EMX Team on Aug 22, 2019 12:09:43 PM

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This is the second post (Post 1) 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.

In the first post of this series, we discussed the differences between a spot market and a derivatives market, but there are a few lingering questions. Why should we believe the price of ETH-PERP will actually track the price of spot ETH/USD (and therefore be a good hedge for an ETH position or allow levered speculation on the price of ETH?) And what’s a “perpetual swap” anyway?

First, to set the stage- futures, perpetual swaps, and even options are all types of derivative contracts. A derivative contract is an agreement between two parties whose value is based on an underlying asset. The specifics of that agreement are different for each type of derivative. The simplest of these is a future.

Futures

Futures are an agreement between two parties to transfer assets at a predetermined price at some point in the future. That point in the future is called the expiration date. When you go long 1 contract of an ETH future that expires at the end of December 2019 for $210, you’re saying “I’ll pay $210 at the end of December 2019 in return for 1 ETH”. If the price of ETH goes up between now and then, you’ve made money because the 1 ETH you receive will be worth more than what you pay. If the price drops, you lose.

Physical Settled vs. Cash Settled Futures

But do I receive that 1 ETH at the end of December? No- the original description of this future describes “physical settlement” where the underlying asset is actually transferred at expiration.

It’s actually much simpler to just transfer the difference in value of the asset at expiration (the “index price”) and the price the contract was transacted at. This is called “cash settlement”. For example, if the price of ETH is $310 at the end of December in the aforementioned example, the short trader can just send the long trader $100. All contracts on EMX are cash-settled.

If the price of ETH goes up an hour after I go long the futures contract, do I really have to wait until the end of December (and hope the price stays high) to realize that gain? No. If there’s an active market for December ETH (ETHZ19), then you can just sell your contract to another trader. The price of the contract should have gone up along with the spot price of ETH because the price of the future at expiration is tied to that spot price of ETH.

Note that due to interest rates and other complications, traders might expect the price of ETH to be different than it is now - and that can affect the price of a future. (If you’re trying to hedge your ETH using a future - and that future’s price moves slightly differently than the spot price of ETH - giving you an imperfect hedge, it is said that there is “basis risk”. The basis risk of a futures contract generally shrinks as the expiration date approaches.)

So, futures generally track the price of the underlying asset pretty well, but what if I want to keep my long position past December 2019? I’ll have to at some point trade out of my December ETH position and trade into a 2020 future position. This can add cost and complexity, unless you’re intent on holding until expiration. Is there a simpler way to get exposure to an underlying asset where I don’t have to worry about expiration?

Yes -  that’s where perpetual swaps come in.

Perpetual Swaps

A perpetual swap, as you might guess, is a derivative contract that never expires. Though, if it doesn’t expire and there isn’t a predetermined exchange of value based on the underlying asset price, what causes it to track the value of an underlying asset - and make it a good vehicle for hedging and speculation? The mechanism to tie the price of the derivative to the price of the underlying spot asset is funding.

Funding is kind of like a futures expiration every 8 hours. Every 8 hours, the price of the swap over that period is compared to the price of the underlying market (or “index price”) and if the price is different, a transfer of value (called a funding payment) takes place between traders with a long position in the swap and traders with a short position. If the price of the swap price has generally been higher than the underlying index over a recent period, long traders will pay short traders the funding amount. This should have a downward effect on the price of the swap as traders would prefer to be short and receive the funding payment rather than be long and pay it.

Perpetual swaps generally track the price of an underlying asset more closely than futures because funding is never more than 8 hours away on EMX.

Should I trade a future or a perpetual swap?

Well, this depends on how long you expect to hold your position, what side position you’re taking (long or short), and what direction you expect funding payments to go.

If you’re going to take a position and hold it until December - or close to it, then perfect - trade the future. But if you expect to trade in and out more often - and you want a contract that more closely tracks the underlying, then trade the swap.

Or, if swap prices are usually higher than the underlying, and thus longs are often paying shorts, and you want to be short, then you may want to trade the swap and earn the funding. You’re effectively being paid to be short, in that case, because so many traders want to be long. This is generally the case with BTC-PERP swaps on EMX, for example.

An Interesting Example: Hedging + Funding

We’ll talk about hedging more in a later post, but let’s say you have 1 BTC on your Ledger and 0.1 BTC deposited at EMX. You can use your BTC on EMX to take a 1 contract short position on BTC-PERP and you now have net zero BTC exposure. You no longer care if the price of BTC does up and down - but, assuming the price of BTC-PERP is generally above the index price (spot BTC/USD), you’re also receiving funding payments every 8 hours. So, you’re getting paid to be “short” (thus enabling other traders to be long, since there must be equal long and short exposure on the platform) - even though you’re actually not short, you’re neutral.

We won’t cover options or other more exotic types of derivatives here. There are benefits to trading both futures and swaps at different times and for different types of traders. The cool thing about derivatives, especally on EMX, is how easy it is to get exposure to a myriad of underlying assets (like Tezos or the Euro!) with just your BTC - and you keep your BTC while you do it. Magical.

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Now put this newfound education to work, and trade derivatives on EMX, with up to 100x leverage. Sign up today at trade.emx.com.

Topics: Trading Series