Financial Products Applied to Crypto

Abstract

Since financial concepts are not as digestible for all readers intended for this book, the following sections have been moved to an appendix. They cover approaches that investors may be tempted to use, in cryptoasset or otherwise, to benefit from potential investments, though with a different risk profile than traditional direct investments. Note, in particular, the important words of caution related to these approaches.

Since financial concepts are not as digestible for all readers intended for this book, the following sections have been moved to an appendix. They cover approaches that investors may be tempted to use, in cryptoasset or otherwise, to benefit from potential investments, though with a different risk profile than traditional direct investments. Note, in particular, the important words of caution related to these approaches.

Leverage and Margin Trading

To maximize gains, traders in the financial industry often use leverage. Compared to a simple investment (purchase), leverage consists of borrowing funds to invest to benefit even more from price appreciation while running even higher risks if prices drop.

The following example is computation heavy but illustrates the benefits and risks of leverage trading. Assume a trader invested $100 in an asset. If the asset price increases by 10%, the trader has this return: 10% (ignoring transaction costs). However, if the trader borrowed another $100 on top (at a 5% interest rate) and invested it in the same asset before the price appreciation, the return would be much higher. In particular, the trader would have $220 in the asset (2 × $100 × (1 + 10%)), which he can sell. He can repay the loan plus the 5% interest: $105. His return, in this case, would be 15% (computed as $\frac{\$220-\$105}{\$100}-1$). In this scenario, the gain with leverage (15%) is much higher than without (10%). However, if the price had dropped (e.g., 10%), then the loss (–25%) would also be bigger than without leverage (–10%). Note that the interest rate on the loan is due no matter what so that potential additional losses are more than proportional to potential additional gains. By borrowing, traders can amplify positions to gain more from price increases while exposing themselves to higher risks if prices fall.

Figure A-1

Performance of a portfolio with or without leverage (vertically), depending on the performance of an asset (horizontally), assuming a 5% interest rate due on the loan

Leverage is also possible in cryptoassets and available through many centralized or decentralized platforms. However, the high volatility of cryptoassets makes them much less appropriate for leveraged positions. To understand this, one must be familiar with the concept of margin trading.

The trader must typically post collateral for the loan to obtain leveraged positions. The collateral is a sort of security for the lender and is usually the asset the trader invests in. It is the “margin” in “margin trading.” The lender can thereby reduce his risk: if the asset’s price decreases below a certain point, the lender can sell the borrower’s asset on his behalf to reimburse the loan. However, this sale represents a substantial risk for the borrower, especially for volatile assets: the asset is disposed of after losing much of its original value. After the sale, the borrower has nothing left, even if the asset’s price rebounds. Not only is the borrowed amount gone, but also the amount initially invested.

Margin trading is, therefore, hazardous for investors in highly volatile assets. Even if the asset price increases eventually, its volatility can “liquidate” many traders on the way.

Cryptoasset sales happening when prices drop (due to the margin of leveraged positions being liquidated) cause prices to drop even further. As the cryptoasset market has traditionally been very leveraged, it constitutes a weighty reason for its volatility.

Derivative Products

Another way to benefit from cryptoassets is through the use of derivative products. A derivative product derives its value from another product (the underlying). For example, the value of a stock option derives its value from the price of a stock.

Call and Put Options

A call option on a stock is the right to buy a stock in the future at a specific price. Like all other derivative products, this is a contract. It is similar to a bet on the future price of the underlying over a specific period.

For a numerical example, assume Google’s stock price is currently trading at $1,000. I buy a call option on Google’s stock, for $50, with a strike price of $1,100 and a maturity of 1 year. In other words, I now pay the premium of $50 to buy a right. The right is that I can (I have the “option” to) purchase Google’s stock next year at $1,100, regardless of its trading price. If Google’s stock trades next year at $1,250, then I exercise the option. Therefore, the call option seller is obligated to sell me the stock at $1,100, even though it is trading at a higher price. I have made a profit because my purchase price plus the premium ($1,100 + $50 = $1,150) is lower than the current trading price of the underlying ($1,250).

On the other hand, if the stock next year trades at $1,075, I do not exercise the option because I am better off buying the stock at $1,075 on the open market than at $1,100. In this case, I let the option expire worthless and have made a loss (the amount I paid for the right, i.e., $50).

The price of the call option derives its value from the underlying stock’s price (among other factors). In other words, if the stock price rises, the option price also rises (all other things equal) because the likelihood of expiring above the strike price increases. A call option can have any product as underlying, from stocks and bonds to commodities, currencies, interest rates, or even other derivative products. Of course, call options also exist with cryptoassets as underlying.

A put option, in contrast, is the option to “sell” an underlying in the future at a specific price. A put option is, in some sense, the opposite of a call option. It works like a call option but with the option to sell rather than the option to buy.

One benefit of using put options is to insure oneself against price drops. For instance, a trader unable to afford a cryptoasset dropping below a particular value can buy a put option for that cryptoasset and that value. For example, a trader can buy a $50,000 Bitcoin and insure himself against the price dropping below $40,000 next year. To do so, the trader would buy a put option on Bitcoin with a one-year maturity and a strike price of $40,000. The trader can exercise the option and sell the asset for $40,000, limiting losses if the price drops below that level. Effectively, a put option is an insurance contract. The trader thereby benefits from the upside potential of the investment and, at the same time, limits the potential downside. Such contracts can, of course, be programmed in a smart contract and be traded decentrally.

Futures Contracts

Alternatively, traders can use futures contracts to express views on future price movements. In a futures contract, the buyer agrees to buy an asset for a specific price at a specific future date. This way, he can lock in a price without having to pay it immediately.¹

Futures often benefit from higher liquidity and lower trading fees than buying the underlying product. Similar to put options, they can provide potentially infinite upside for a limited downside. They can therefore be used to hedge against some risks or for speculation. The cryptoasset trading exchange Binance is among the largest futures exchanges in the world.

Many other derivative products exist for cryptoassets, just like other asset classes. Interested readers should refer to literature on financial derivative products or risk management.