Derivatives in DeFi

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What Are Derivatives?

Financial derivatives are a versatile alternative to traditional investing.

They provide a way for investors to manage risk, protect their investments, and potentially profit from market movements without directly owning the underlying asset.

In DeFi, the value of a financial derivative is generally derived from an asset or a group of assets, such as ETH or a liquidity pool.

In traditional finance, their value can be derived from things like stocks, commodities, currencies, or interest rates. Derivatives can be bought and sold, unlocking a new avenue of trading beyond just buying and selling assets.

Different types of derivatives (such as perpetual futures and options) vary greatly, and each of them serve a specific purpose.

DeFi Derivatives: Derivatives such as options and perpetual futures unlock a greater amount of flexibility when compared to simply holding an asset.

What Are Derivatives Useful For?

There are several reasons why traders and investors may choose to use financial derivatives instead of simply buying an asset.

Let's go over some of the common use cases for derivatives:

1. Leverage: Financial derivatives often allow traders to use leverage. Leverage means being able to control a larger amount of an asset with a relatively small initial investment. Using leverage amplifies potential gains, while also increasing potential losses.

2. Speculation: Traders can also use derivatives to make guesses about what might happen in the future. If a trader believes ETH will go up in price, they could use a financial derivative that gives them the potential to profit from ETH going up in price, such as a call option or a perpetual futures contract.

3. Hedging: Derivatives can be used to hedge existing positions. Hedging means reducing the potential risks of an asset or investment without having to sell the asset. It can help traders protect their investments against negative price movements.

4. More Flexibility: Derivatives offer more flexibility compared to traditional investments. They can be customized to fit various strategies, timeframes, and risk appetites, making different derivatives useful as powerful and flexible tools for investing.

Test Yourself!

What is the primary purpose of financial derivatives in DeFi?

  • To offer a way for investors to manage risk and potentially profit from market movements.

  • To facilitate direct asset ownership and trading.

  • To provide a platform for high-frequency trading.