When you first start trading cryptocurrency, there can be a plethora of terms to learn, and understanding them could be the difference between a good trade and a great trade.
Some of the first terms you may come across but not fully understand are Spot trading and Derivatives trading. Knowing the difference between the two can open up new ways of trading crypto.
What’s the difference between Spot and Derivatives?
Spot and derivatives are two terms that are often used in the world of cryptocurrency. But what exactly do they mean?
Spot refers to the physical purchase of a currency or asset such as Bitcoin, meaning that it can be bought or traded immediately (on the spot). These can be bought either with fiat, stablecoins or with other cryptocurrencies.
For simplicity, Spot traders often use exchanges such as Binance to trade on, as these exchanges typically function 24/7 and can action a trade as soon as the buy or sell conditions have been met.
Derivatives are financial instruments that derive their value from the value of another asset (the underlying). There are several forms of derivatives:
- Futures – an agreement to buy or sell an asset or financial instrument at a predetermined price on a specific date in the future. These are exchange traded instruments, meaning that they can only be traded on structured exchanges.
- Options – an agreement that gives the holder the option to buy or sell an asset at a predetermined price on a specified date. There is no obligation on the holder to buy or sell.
- Perpetual Swaps – a form of Futures contract, where neither the price or date is set and the contract is open in perpetuity. These trade much more like Spot assets, but have extra considerations such as Funding Rates.
Some exchanges will only offer spot trading, others are only derivatives and some exchanges, such as Deribit, support spot trading and both futures and options trading.
What are the advantages and disadvantages of Spot?
Spot is often seen as the more traditional and most straightforward way to invest in cryptocurrency, as it allows investors to directly own and use digital assets. There’s also no risk of losing more than you put in and requires no work on your part once you’ve bought the asset – you can just leave it as you own the actual asset.
While this may be seen to many investors as a benefit, it limits possibilities as there’s no way to profit when the market moves down. As the market value moves down, so does the value of your assets.
Spot trading generally comes with lower risk, which means the potential gains are lower when compared to most kinds of derivatives trading.
What are the advantages and disadvantages of Derivatives?
One of the main benefits of derivatives contracts is that they provide greater flexibility and the chance for more sophisticated trading strategies. They can also be used to hedge against risk. In other words, if the market value goes down, that doesn’t necessarily mean you’re making a loss, unlike with Spot trading.
Also dissimilar to Spot trading, buying derivative contracts doesn’t require you to actually hold any Cryptocurrency, which can be favourable in certain cases such as tax and crypto custody.
Derivatives as a whole can also be extremely complex, with traders running the risk of losing a lot more capital than they put in. Even the same type of contract can be different on different exchanges, because how their value is calculated can be different. For this reason, some traders stay away from derivative contracts, and instead stick to Spot trading.
While Spot and Derivatives both have their own advantages and disadvantages, it’s useful for a trader to understand both, even if they only trade with one. By intimately understanding both, a trader could gain a trading advantage, as they may get a better insight into the market, and perhaps predict its movement more accurately.
Disclaimer: Nothing within this article should be misconstrued as financial advice. The financial techniques described herein are for educational purposes only. Any financial positions you take on the market are at your own risk and own reward. If you need financial advice or further advice in general, it is recommended that you identify a relevantly qualified individual in your Jurisdiction who can advise you accordingly.