Chapter 2. Financial Markets and Trading Instruments

Chapter 2. Financial Markets and Trading Instruments

What is a financial instrument?
To put it simply, a financial instrument is an asset that can be traded. Examples can be cash, precious metals (such as gold and silver), documents confirming ownership of something (for example, business or resources), the right to supply or receive cash, and much more. Financial instruments can be complex, but the basic idea is that, whatever they are and whatever they represent, they can be traded.

There are different ways to classify financial instruments. According to one classification, instruments can be cash or derivative. Derivatives are instruments derived from others (for example, from cryptocurrencies). Also, financial instruments can be based on debt or equity ownership.

But where do cryptocurrencies belong? They can be viewed in different ways and attributed to more than one category. According to the simplest classification, these are digital assets. However, cryptocurrencies can potentially form the basis of a completely new financial and economic system.

In this sense, cryptocurrencies form a completely new category of digital assets. In addition, as the ecosystem develops, many new categories may appear that were not previously possible. Early examples of this can already be observed in the decentralized finance sector.

What is the spot market?
In the spot market, financial instruments are traded for "immediate delivery". In this context, delivery means the exchange of a financial instrument for cash. It may seem that there is no need for such a difference, but in some markets delivery does not occur immediately. For example, in futures markets, assets are delivered later (when the futures contract expires).

Simply put, the spot market can be represented as a market where transactions take place "on the spot" (hence the name: spot – "place"). Since settlements on such transactions occur immediately, the current market price of an asset is often called a spot price.

What does this mean in the context of cryptocurrency markets? On cryptocurrency spot markets, you can exchange one coin for another. If you want to exchange one cryptocurrency for another, then just go to the corresponding spot market, and when your application is executed, the exchange takes place instantly. This is one of the easiest ways to trade cryptocurrencies.

What is Margin trading?
Margin trading is leveraged trading. In essence, margin trading multiplies the result – both winning and losing. A margin account gives traders more access to capital and partially eliminates counterparty risk. How? Traders can trade the same position, but hold less capital on the exchange.

When it comes to margin trading, you can often hear the terms margin and leverage. Margin is the amount of your own capital that you pledge. And leverage, or leverage, is how much you multiply your capital. 2x leverage means that you open a position that is twice your margin. Leverage 4x – four times more, etc.

However, one should beware of liquidation. The more leverage you use, the closer the liquidation price is to your entry. If your position is forcibly liquidated, then you risk losing the entire margin. Therefore, before starting margin trading, you should be aware of all the risks.

Margin trading is widely used in the stock, commodity and currency markets, as well as in the Bitcoin and cryptocurrency markets. In more traditional conditions, the borrowed funds are provided by an investment broker. In the case of cryptocurrencies, funds are usually lent by the exchange for a commission. However, sometimes borrowed funds can come directly from other traders on the platform. At the same time, the interest rate (commission) is usually variable, since it is determined by the open market.

What is a derivative market?
Derivatives are financial assets whose value is based on something else – an underlying asset or a basket of assets. The underlying assets can be, for example, stocks, bonds, commodities, market indices, or cryptocurrencies.

A derivative product is, in fact, a contract between several parties. Its price is based on the underlying asset. Whatever the asset is, the bottom line is that the value of the derivative is derived from it. Examples of derivative products: futures, options and swaps.

According to some estimates, the derivatives market is one of the largest in general. Why? Because derivatives can exist for almost any financial product – even for the derivatives themselves. Yes, derivatives of derivatives are possible. And then derivatives of these derivatives can be created, etc. Resembles a house of cards that can fall down at any moment? Perhaps this is not far from the truth. Some believe that the derivatives market played a key role in the 2008 financial crisis.

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What are futures contracts?
A futures contract is a derivative product that allows traders to speculate on the future price of assets. The parties to the contract agree to make the settlement on the expiration date, that is, when its term expires. As with other derivatives, the underlying asset of the futures can be anything: cryptocurrencies, commodities, stocks, bonds, etc.

The expiration date is the last day of trading activity for this contract. At the end of this day, the contract expires with the last trading price. The settlement of the contract is determined in advance. It can be a cash payment or a physical delivery.

In the case of physical delivery, the underlying asset is directly exchanged. For example, barrels of oil are supplied. When making cash payments, it is not the underlying asset itself that is transferred, but its value (for example, in the form of cash or cryptocurrency).

Futures products are a great way for traders to speculate on the price of an asset. But what if they want to keep the position even after the expiration date?

There are perpetual futures for this. Their main difference from the usual ones is in the absence of an expiration date. So traders can speculate on the price of the underlying asset without worrying about the expiration.

However, there is one problem. What if the price of the perpetual futures is very different from the price of the underlying asset? Since there is no expiration date, there may be a significant, permanent discrepancy with the spot market in the perpetual futures market.

Therefore, perpetual futures contracts have a financing rate that traders pay to each other. Imagine that perpetual futures are trading above the spot market. Then the financing rate will be positive, that is, long positions (buyers) pay a commission to short ones (sellers). This encourages buyers to sell, which causes the contract price to fall, approaching the spot price. Conversely, if perpetual futures are traded below the spot market, the financing rate will be negative. In this case, short positions pay long positions to raise the contract price.

Perpetual futures are very popular among cryptocurrency traders.

What are options?
An option is a derivative product that gives traders the right, but not the obligation, to buy or sell an asset in the future at a certain price. The main difference between options and futures is that traders are not required to make calculations on options.

When traders buy options, they speculate on which way the price will change.

There are two types of options: call options and put options. A call option is a bet on price growth, and a put option is a fall.

Like other derivatives, options can be based on various financial assets: market indices, commodity resources, stocks, cryptocurrencies, etc.

Options make possible complex trading strategies and risk management techniques, such as hedging. In the context of cryptocurrencies, options can be most useful to miners who want to insure their large cryptocurrency reserves. This way they will be better protected from events that may adversely affect their funds.

What is the Foreign exchange market (Forex)?
In the foreign exchange market (Forex), traders can exchange one currency for another. In essence, the foreign exchange market determines the exchange rates of currencies.

Currencies are often considered "safe haven" assets. Even in the case of fiat-backed stablecoins, the very name indicates that the asset should be protected from volatility. But while this is true to some extent, currencies can also be subject to significant market fluctuations. Why? Because the value of currencies is also determined by supply and demand. In addition, it may be affected by inflation, as well as other market forces related to global trade and investment, and geopolitical factors.

How does the foreign exchange market work? Investment banks, central banks, commercial companies, investment firms, hedge funds and retail traders trade currency pairs. The foreign exchange market also allows you to convert currency in international trade settlements.

Currency traders usually use day trading strategies, such as scalping with leverage, to multiply their income. We will tell you more about this later.

The foreign exchange market is one of the main components of the modern global economy. In fact, it is the largest and most liquid financial market in the world.

What are leveraged tokens?
Leveraged tokens are trading assets that allow you to speculate on the price of a cryptocurrency with leverage, but without the usual requirements for positions with leverage. This means that there is no need to worry about margin, collateral, financing and liquidation.

Leveraged tokens are an innovative financial product that appeared thanks to the blockchain. For the first time such tokens were presented on the FTX derivatives exchange, but then alternative implementations appeared. Nevertheless, their main idea is the same: to tokenize open positions with leverage. What does it mean?

Leveraged tokens represent open perpetual futures positions in tokenized form. Remember we said it was possible to create derivatives of derivatives? Leveraged tokens are a good example, since their value is based on futures positions, which are also derivatives.

Leveraged tokens are a great way to simply bet on a cryptocurrency with leverage.