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This handbook provides you with a comprehensive overview of what crypto derivatives are, how they work, and how crypto derivatives market making is done.
Introduction to Crypto Derivatives & Crypto Derivatives Market Making in 2024
Crypto derivatives market making is becoming increasingly sought after as crypto derivatives markets have seen a steep rise in volume at the start of 2024. According to Coingecko report data, by early 2024 crypto derivatives volume had already reached almost 75% of total crypto trading volume. At the same time, spot volume has plummeted tremendously this August, as reported by Coindesk
What are crypto derivatives?
As the name already suggests, derivatives are derived from an underlying crypto asset. They can be seen as a sort of financial contract between two parties that is based upon the future price of the underlying crypto asset. The advantage of such a practice is that an investor does not need to actually possess the underlying asset to be able to profit (or lose) from speculating on its future price moves, meaning you can gain exposure even without buying the asset itself.
Derivatives are used as a means for maximizing profits (esp. incl. leverage), but also as hedging strategies, as well as to diversify a portfolio. It should be obvious but has to be mentioned that this kind of trading is not without risk and one should always be mindful of that and do proper research on each trading strategy, asset, legal framework, and exchange.
Futures vs. Options
There are different types of derivatives such as crypto futures, options, perpetuals and swaps. The main difference between futures and options is, that futures are binding, meaning they force you to buy/sell the asset at the predetermined condition (date), while options give you the right to do so but do not force you to. Open futures orders run a high risk of being liquidated, but are not affected by time decay, while the value of options decreases the closer they get to their expiration date and they usually require a premium.
Although futures tend to have better liquidity and are more cost-effective than options are, the latter often involve less risk. Which choice a trader makes therefore depends on personal preferences and factors such as risk tolerance and available capital. You can find an overview of the best crypto options trading platforms of 2024 here.
Perpetuals & Swaps
Contrary to futures and options, perpetuals (sometimes called “perps”) do not have a pre-determined execution date and in some cases these orders can therefore persist quasi-indefinitely if certain criteria are met (e.g. the trader holds enough crypto).
Swaps are contracts between two parties to exchange cash flows based on a pre-established formula at a later time. Like forwards, they happen OTC (over-the-counter), i.e. not traded on exchanges.
What are some key characteristics of crypto derivatives trading?
Auto deleveraging: If a position can’t be liquidated at a price that is higher than the bankruptcy price and if there’s not sufficient insurance to cover the loss, an exchange's auto deleveraging system can automatically deleverage an opposing position from a designated trader in the event of liquidation.
Insurance: Even if a trader’s holdings fall below the maintenance margin level, they can help traders prevent auto-deleveraging.
Stop/loss take profit: Allows a trader to define their order's very bottom and top prices, allowing them to automatically get out while the crypto derivatives market conditions are good.
Partial-close orders: Allows traders to reap partial profits while still benefiting from the expanding market by partially closing their orders.
What are the biggest exchanges for crypto derivatives and crypto derivatives market making?
Centralized exchanges:
Looking at overall crypto derivatives market share and volume, CEXs still dominate the crypto derivatives market by a long shot compared to DEXs.
With an almost 60% share in the crypto derivatives market and over $1.5 billion in trading volume, Binance clearly takes the lead, followed by OKX, Bybit, Kucoin, and Gate.io.
Decentralized exchanges:
When looking at DEX derivatives trading, dYdX spearheads in this regard. This DEX even specialized in this particular field, offering perpetual trading options for more than 35 cryptocurrencies including BTC, ETH, ADA, and DOGE.
What are some key characteristics of crypto derivatives trading?
Auto deleveraging: If a position can’t be liquidated at a price that is higher than the bankruptcy price and if there’s not sufficient insurance to cover the loss, an exchange's auto delevaraging system can automatically deleverage an opposing position from a designated trader in the event of liquidation.
Insurance: Even if a trader’s holdings fall below the maintenance margin level, they can help traders to prevent auto-deleveraging.
Stop/loss take profit: Allows a trader to define their order's very bottom and top prices, allowing them to automatically get out while the market conditions are good.
Partial-close orders: Allows traders to reap partial profits while still benefiting from the expanding market by partially closing their orders.
Benefits & risks of crypto derivatives trading
The most obvious benefit of crypto derivatives trading are the potential financial gains that can be made - if it goes well. And these potential gains are increased even more when leverage is used. Another important reason to engage in crypto derivatives trading is the fact that - if done correctly - it can be a great hedging option in the volatile crypto markets.
However, crypto derivatives trading also carries a number of risks, including - as always in crypto - volatility. Trading derivatives entails making predictions - or assumptions - about the price changes of an underlying asset that is potentially highly unstable, and trading with leverage increases this risk of substantial losses even further. The legal ambiguity surrounding dealing in derivatives in some jurisdictions is another serious concern. Therefore, before engaging in derivatives trading, traders should review the rules and regulations of their own country.
What are the biggest exchanges for crypto derivatives and crypto derivatives market making?
Centralized Exchanges: Looking at overall crypto derivatives market share and volume, CEXs still dominate the crypto derivatives market by a long shot compared to DEXs.
With almost 60% market share and over $1.5 billion in trading volume, Binance clearly takes the lead, followed by OKX, Bybit, Kucoin, and Gate.io.
Decentralized Exchanges: When looking at DEX derivatives trading, dYdX spearheads in this regard. This DEX even specialized in this particular field, offering perpetual trading options for more than 35 cryptocurrencies including BTC, ETH, ADA, and DOGE.
Crypto Derivatives Market Making
Generally speaking, a market maker is an entity that maintains a market in a particular crypto derivatives instrument by standing ready to buy and sell that instrument. Crypto derivatives market making is a means of providing liquidity to a crypto derivatives market by way of providing derivatives contracts for sale. This requires that the crypto derivatives market maker set both the bid and ask price for the options contract, aiming to profit from the spread between the bid and ask prices.
Market making for crypto derivatives differs from spot market making in several ways and is a highly complex endeavor. It requires a well-thought-out approach and careful execution. A crypto derivatives market maker needs to be highly flexible and adaptable to successfully manage positions, hedge efficiently, increase benefits, and reduce risk.
High-quality market making always necessitates the crypto derivatives market maker to have a thorough understanding of the underlying asset and the relevant options market, as well as the skills needed to monitor the market and spot opportunities to place buy and sell orders on that market using sophisticated software tools and algorithms. Crypto derivatives market making is not merely a handy tool for experienced traders, it is vital to the health and stability of any crypto derivatives market.
Crypto Options Market Making
In crypto options market making, the market maker provides liquidity by continuously creating and offering options contracts for sale. These contracts give the options holder the right, but do not obligate them, to buy or sell an underlying asset at a pre-determined price tied to a specific expiration date.
Although it might not seem obvious at first glance, crypto options market making for token projects can be highly beneficial for them, because it can be used as a hedging strategy for token inventory, so as to follow a delta-neutral approach. This way, no matter which way the market goes, token projects could significantly reduce potential losses. But in order to successfully implement such strategies, one needs a profound understanding of the underlying asset as well as the crypto option market dynamics. Careful assessment and diligent risk management are key factors for any crypto derivatives market maker to constantly consider.
And what about projects that do not have options markets? For projects without options markets, creative strategies can be introduced, such as using options markets with a solid enough correlation to the token price for hedging purposes by a competent crypto derivatives market maker.
Who provides crypto derivatives market making?
Market making for derivatives is offered by professional crypto derivatives market makers such as Autowhale, who also focus on and are able to implement market making strategies for derivatives accordingly. Autowhale analyzes and evaluates the underlying asset and derivatives markets to create and implement a crypto derivatives market making strategy that perfectly suits the needs of the client. Through close consulting with the client, crypto derivatives trading strategies are meticulously tailored to their specific goals and objectives.
