DeFi 101_ Introduction to Decentralized Derivatives with @FlashTrade_.mp3
What are Derivatives? Derivatives in decentralized finance are contracts based on the value of other assets like cryptocurrencies or stocks. They let people bet on asset price changes, hedge risks, or gain exposure to different markets directly via blockchain technology, without needing traditional financial brokers. This setup reduces costs and makes advanced financial strategies accessible to more people. **
The easiest way to explain this is with an example. Imagine a typical market where someone buys an orange for $2 and a week later, the price of oranges rises to $2.20, so you decide to sell that orange. You hand over the orange and pocket the 20 cents profit. On the other hand, a derivative is like making a bet on what the price of the orange will be in the future. No actual oranges are exchanged, yet you are still exposed by the price changes of oranges, which means that, in a derivatives market, you don't need to actually own the orange to bet on its price. When you are using a derivative you are essentially betting on the future price of X asset.
Why would I use derivatives?
The reason you use derivatives is because you are able to multiply part of your money, so it’s very capital efficient. It offers several advantages, such as leverage that helps boost the size of your position. For example, derivatives like perpetual swaps allow users to engage in leveraged trading, enabling them to open positions that are much larger than their actual holdings which would translate in amplified profits, although it also increases risks.
What types of derivatives exist?
There are two prominent types of derivatives which are futures and perpetual contracts, both of which allow traders to speculate on the future prices of assets without needing to own them.
Futures:
These are agreements to buy or sell an asset and to predetermine future price. It enables traders to hedge against price volatility or speculate on movements of crypto assets. By entering into a futures contract, traders commit to buying or selling the underlying asset at a specified price on a certain date, regardless of the market price at that time. This can be a powerful tool to make money although it requires careful management.
Perpetual:
Unlike traditional futures, perpetual contracts do not have an expiration date, allowing traders to hold a position for as long as they desire. This type of derivative is highly popular on platforms like dYdX. Perpetual contracts are similar to futures but include a mechanism to anchor the market price to the underlying asset through a funding rate that adjusts based on the positions held by traders. This funding rate ensures that the perpetual contract's price does not deviate significantly from the actual market price (spot market) of the underlying asset. Usually, perps offer high leverage which enables traders to multiply their exposure to price movements with a smaller initial capital, thus resulting in more profits or bigger losses of course.
Both futures and perpetuals in DeFi are underpinned by smart contracts rather than traditional financial institutions, which means they operate in a trustless environment where counterparty risk is minimized. Transactions and settlements are performed automatically without the need for intermediaries, providing transparency and reducing transaction costs.
