Derivatives in Crypto, Explained

Derivatives are generally used to hedge risk or to speculate on the price of the underlying asset in case it changes.

Derivatives are used in many areas but mainly for hedging purposes, namely when investors want to protect themselves from price fluctuations. In this case, signing a contract to buy an asset for a fixed price would help mitigate related risks. Another way to take advantage of derivative trading is speculation, when traders are trying to predict how the asset’s price might change over time. That is the reason why high-profile American investor Warren Buffet once called derivatives “financial weapons of mass destruction,” sharing a commonly held view that they were to blame for the 2007-2008 global financial crisis.

There are many ways in which derivatives can be applied in real life. For instance, prior to the aforementioned crisis, major United States holding company Berkshire Hathaway started selling put options on four equity indexes, including the S&P 500 and FTSE 100. A put option is a form of derivative that gives the owner the right, but not the obligation, to sell an underlying asset to the seller of the put at a specified price by a predetermined date. In this case, Berkshire Hathaway offered investors the chance to purchase an option premium and therefore buy the ability to sell their stocks at an agreed-upon price and date. When the date finally came, they could earn money by selling a stock whose price had visibly decreased. However, if the price has been rising through that period of time, the company received the option premium. In this particular case, Berkshire Hathaway took the risk and earned around $4.8 billion as a result.

Another interesting example of using derivatives comes from the airline business. As airlines are heavily dependent on jet fuel, the price of which continually sees ups and downs, it is very useful for the business to implement appropriate derivative hedging strategies. The world’s largest low-cost carrier, Southwest Airlines, which operates in the U.S., is a well-known example of success in this area. Because of its well-designed hedging program, the airline managed to lock crude oil prices at a very low rate and has therefore been paying between 25% and 40% less for its jet fuel than its competitors for years.

Some use cases are nowhere near traditional finance systems. For example, there is a whole segment of weather derivatives aimed to protect farmers, commodity providers and others from weather-related losses, such as frost or hurricanes.