Bitcoin derivatives, explained: gaining deeper market understanding

Bitcoin derivatives, explained: gaining deeper market understanding

Demystifying bitcoin futures, perpetual swaps and options: how they work and what their indicators can tell us about the state of the market.

The headline event of the year — the Bitcoin halving — proceeded without a hitch, the protocol successfully slashing miners’ rewards from 6.5 to 3.25 BTC. Although, apart from Jamie Dimon, most of us held little doubt about that 😂 

Bitcoin issuance slowed down, officially making it scarcer than gold. Unlike its tangible counterpart, however, Bitcoin has yielded significantly higher returns over the years. 

Even more, Bitcoin is one of the most profitable investments among all asset classes, consistently outperforming stocks, bonds, and commodities over various time frames. BlackRock’s calculations featured in the latest Coinbase report illustrate this outstanding performance well, with Bitcoin registering a 124% annualized return, vs its runner-up S&P500’s 13%. 

 This remarkable track record continues to attract a broad spectrum of investors, from individuals seeking a hedge against inflation to institutions looking to diversify their portfolios. Yet, with its rise, the complexity of the market has also grown, introducing a range of financial instruments that might seem daunting at first glance. Bitcoin derivatives are important, yet often misunderstood elements that play a big role in the market’s dynamics, which means they are worth monitoring even for those who do not intend to actually use them. 

This newsletter aims to demystify Bitcoin derivatives, show how they operate, and most importantly – what their metrics can tell us about the state of the market. I will name just some of the indicators I follow, the whole list being too long for the newsletter’s format. However, I am thinking about creating an online course about different crypto-related metrics and how to read them – please let me know if this subject would be interesting for you.

Bitcoin derivatives and their metrics 

Derivatives are contracts derived from the value of an underlying asset—in this case, Bitcoin. They allow investors to speculate on the future price movements of Bitcoin, as well as protect (hedge) their current holdings.  

The main Bitcoin derivatives are futures (including perpetual swaps) and options – contracts obligating/allowing to buy/sell BTC at a (predetermined) future date and price. Different derivatives represent different trading strategies, and their key indicators reveal various insights about the Bitcoin market.

Bitcoin futures 

Classical BTC futures have become the favorite instrument of the traditional finance players willing to bet on Bitcoin, thanks to the Chicago Mercantile Exchange. It launched BTC futures back in 2017, and even if some exchanges tried to follow in its steps, CME remains an incontestable leader. 

BTC futures traders enter contracts to either buy or sell Bitcoin at a predetermined price at a future date, usually at the end of a trimester. For this, it is unnecessary to own BTC, CME grants loans based on collateral posted by the traders, and the settlement is in cash. This setup allows participants to engage in the futures market with leverage, amplifying potential gains while also increasing risk exposure. 

The cost of the loan, known as the initial and maintenance margins, depends on the current interest rate, as well as regulations, BTC volatility, leverage, and other things. 

Open interest in CME BTC futures (number of outstanding contracts) gives us an important insight into the market sentiment of TradFi players. As it happens, this sentiment has gotten unprecedentedly optimistic lately: by the end of March, CME registered over $11.5 billion of open contracts (source: Coinglass), which is x4 more than during the previous Bitcoin bull run. 

Bitcoin perpetual swaps 

In the crypto space, the most popular type of BTC futures are perpetual swaps, affectionately called perps. These are cash-settled futures contracts without expiration or settlement date, usually accessed via centralized crypto exchanges (Binance, Bybit, and Bitget being the biggest ones). They are relatively easy to use and attract a lot of amateur traders. 

Indeed, unlike traditional futures, perps do not require a broker account and do not have a maturity date (no need to roll one’s position at the end of a trimester). Exchanges’ algorithms ensure automatic calculations of initial and maintenance margins, liquidating positions when the Bitcoin price falls/rises beyond a certain threshold. 

An interesting graph based on the BTC perps is the liquidation map, like this one from Coinglass. It tracks open positions in real-time, allowing to see the amounts that could be liquidated if BTC rises (short liquidations) or falls (long liquidations). This gives an idea of an immediate market sentiment, together with concrete price thresholds and amounts at stake. 

Additionally, it helps anticipate potential cascading liquidations – situations when big liquidations trigger significant market shifts on their own. For example, if the BTC price suddenly drops and forces the selling of large long positions, sometimes the latter won’t be able to find immediate buyers, and the selling price will be dropping further to fill the selling at ever lower prices, pulling down the BTC price.  

Bitcoin options 

BTC options are a much more complex instrument, rarely used by amateurs. Unlike with futures, an options investor is not obligated to buy or sell an asset at the contract expiry date, which adds more parameters to consider: volatility, time value, time decay… Indeed, an option’s price can decrease only because of low volatility or an approaching maturity, without any price movement of an underlying asset.

Trading options requires deep financial knowledge and is almost exclusively reserved for professionals, who often use it to hedge their crypto holdings. 

Bitcoin options open interest increased 74% in the first quarter to a new all-time high above $30B. This increase is a sign of the deepening of derivatives markets, which now allow traders to put on more sophisticated positions, as well as for actors like miners to hedge their income exposure. 

Although several crypto exchanges now offer BTC options trading, the biggest platform with the best liquidity is still Deribit, a pioneer in this derivative type. 

Conceived as an independent, borderless, and accessible money, Bitcoin has become a global financial asset. Whether we like it or not, its price is now influenced by a wide range of factors: technical (e.g. related to mining), ecosystem (layer-2s development), macroeconomic (e.g. Fed’s interest rate), financial (e.g. derivatives), and others.

Let me know if you wish to learn more about the metrics I am following here on Substack or in DMs on LinkedIn or Twitter.