Treat this as part 1 of this series. Derivatives is a complicated subject and attempting to fit in all of it in one post is a sure shot recipe to drive you away from my blog, never to return. So I’ll keep it to the minimum, introducing essential concepts and using examples as far as possible. I’m not getting into technical concepts here. The intent is for you to get a basic grasp on the subject.
Let’s stick with Bitcoin, to begin with. Bitcoin is currently trading at $34000 (July 5). I give you two options here for Bitcoin’s price on July 31. Which will you pick?
- $30,000 or lower on July 31
- $38,000 or above on July 31
If you chose option 1, you are bearish. A bear. You are short on Bitcoin.
If you chose option 2, you are bullish. A bull. You are long on Bitcoin.
Get acquainted with this. There’s no way around it. You’ll hear it all the time. Selling is going short, which is bearish. Buying is going long, which is bullish.
Now, if you trade normally (in the spot market), say you buy one Bitcoin today at $34,000. If Bitcoin settles at $30,000 on July 31, you’ve lost $4000. If Bitcoin moves up to $38,000 on July 31, you’ve gained $4000.
Is that the only possible trade there? What if I told you, you can sell Bitcoin first and buy it later. Let’s say you align with view 1 outlined above ($30,000 or lower on July 31). In that case, you can sell bitcoin today at $34,000, and buy it on July 31 for $30,000 (assuming view 1 plays out), making a gain of $4000.
But how can I sell something I do not own?
Here’s where derivatives come in.
If you’ve ever taken a home loan, you’d know you need to put some down payment to avail of the loan. Let’s say the house costs $1 million. The bank will expect you to put a down payment of, say 15%, that’s $150,000 before they lend you the balance. That $150,000 allows you to avail a $850,000 bank loan. Double that down payment to say $300,000, and now the bank may be willing to lend you $1.7 million. This down payment can be thought of as a margin.
Now let’s think of the same example in the context of cryptocurrencies. Let’s say, you’ve got 0.1 BTC in an exchange. At today’s value, that’s worth $3400. With derivatives, you can put forth this 0.1 BTC as a margin. By doing so, the crypto exchange (think Binance, Kucoin, and so on) will offer you leverage. By this I mean they will let you trade for a higher value. Go back to the example of the bank. It offered you $850,000 when you put forth a $150,000 margin. That’s a 5.67X. In the same manner, the exchange will offer you multiples and these can range up to a 100X.
What this means is, if you opt for a 5Xwith your 0.1 BTC (worth $3400), you can basically conduct a trade worth $17,000.
Now let’s assume Bitcoin moves from $34,000 to $36,000. In the normal (spot trading) case, your 0.1 BTC worth $3400 would grow to $3600. A profit of $200.
But with your leveraged position (5X), putting that 0.1 BTC down as margin. You were able to build a position of $17,000, basically 0.5 BTC. At $36,000, that 0.5 BTC is worth $18,000. Your profit is $1000. Amazing right?
Well, it isn’t all so rosy. What is Bitcoin dipped from $34,000 to $32,000. Normal, spot trading case, you’ve lost $200. Derivatives position, with the leverage you availed of, that’s a loss of $1000. So your initial investment of $3400 is worth $2400. Oops.
That was a 5X multiple which, when the trade went against your favoured position, eroded 30% of your capital.
What if you’d availed of a 25X leverage? Basically, your 0.1 BTC margin ($3400) would allow you a trade of $85000. Normally an exchange would not allow you such a position. But then there are a number of factors in play, including the rest of your positions and stuff. Here, let’s assume you manage that multiple. What happens here now is that when Bitcoin falls by $100, you are losing $2500. If Bitcoin falls by $200, you’ve lost $5000. You’re liquidated. That didn’t take long, right?
And that is exactly why derivatives trading is a double-edged sword (hence, the featured image). Summing up,
- It’s not just your profits that get multiplied. It’s your losses too
- Do not get swayed by the opportunity to use a high multiple
- Trade derivatives only if you’re completely sure of how it works and what’s the loss you can incur
- Always use safeguards in your position. Think STOP LOSSES
- If you’re a newcomer to trading, just stay away from this
Like I said earlier, the intent of this post is just to introduce the topic. Derivatives is a massive field. There are options, futures, swaps and a bunch of other concepts within. I’ll try and cover more along the way. But I really hope this helped clear some concepts and instil some realism in expectations.