Leverage and hedging strategies are powerful ways to use derivatives contracts, but traders usually succumb to these three major mistakes.
Novice traders are usually drawn to futures and options markets due to the promise of high returns. These traders watch influencers post incredible gains, and at the same time, the multiple advertisements from derivatives exchanges that offer 100x leverage are at times irresistible for most.
Although traders can effectively increase gains with recurring derivatives contracts, a few mistakes can quickly turn the dream of outsized gains into nightmares and an empty account. Even experienced investors in traditional markets fall victim to issues particular t cryptocurrency markets.
Cryptocurrency derivatives function similarly to traditional markets because buyers and sellers enter into contracts dependent on an underlying asset. The contract cannot be transferred across different exchanges, nor can it be withdrawn.
Most exchanges offer options contracts priced in Bitcoin
, so the gains or losses will vary according to the asset’s price fluctuations. Options contracts also offer the right to acquire and sell at a later date for a predetermined price. This gives traders the ability to build leverage and hedging strategies.
Let’s investigate three common errors to avoid when trading futures and options.
Convexity can kill your account
The first issue traders face when trading cryptocurrency derivatives is called convexity. In this situation, the margin deposit changes its value as the underlying asset’s price oscillates. As Bitcoin’s price increases, the investor’s margin rises in U.S. dollar terms, allowing additional leverage.
The issue emerges when the opposite movement occurs and BTC price collapses; consequently, the users’ deposited margin decreases in U.S. dollar terms. Traders often get too excited when trading futures contracts, and positive headwinds reduce their leverage as BTC price increases.
The main takeaway is that traders should not increase positions solely due to the delivery caused by the increasing value of margin deposits.
Isolated margin has benefits and risks
Derivatives exchanges require users to transfer funds from their regular spot wallets to futures markets, and some will offer an isolated margin for perpetual and monthly contracts. Traders have the option to select between cross collateral, meaning the same deposit serves multiple positions or is isolated.
There are benefits for each option, but novice traders tend to get confused and are liquidated due to failing to administer the margin deposits correctly. On the other hand, isolated margin offers more flexibility to support risk, but it requires additional maneuvers to prevent excessive liquidations.
To solve such an issue, one should always use cross margin and manually enter the stop loss on every trade.
Beware, not every options market has liquidity
Another common mistake involves trading illiquid options markets. Trading illiquid options drives up the cost of opening and closing positions, and options already have embedded expenses due to crypto’s high volatility.
Options traders should ensure the open interest is at least 50x the number of contacts desired to trade. Open interest represents the number of outstanding contracts with a strike price and expiration date that have been previously bought or sold.
Understanding implied volatility can also help traders make better decisions about the current price of an options contract and how they might change in the future. Keep in mind that an option’s premium increases alongside higher implied volatility.
The best strategy is to avoid buying calls and puts with excessive volatility.
It takes time to master derivatives trading, so traders should start small and test each function and market ahead of placing large bets.