FOLLOW THE MECHANISM
- 1Contract
Terms define reference asset, size and payoff.
- 2Margin
Collateral supports future settlement obligations.
- 3Revalue
Price and other payments change account equity.
- 4Settle or liquidate
The mechanism transfers gains and losses or closes exposure.
A conceptual sequence. Real implementations can add steps, intermediaries, and conditions.
A contract about an asset
A derivative’s payoff depends on an underlying price, rate or event. A future defines an exchange or settlement obligation; an option gives its buyer a specified right under its terms. Crypto derivatives can be operated by centralized venues or onchain protocols. Holding a derivative does not necessarily mean owning the underlying token or being able to use it on a blockchain. The contract defines what is owed, when it is measured and which asset settles the obligation.
Margin supports an obligation
Margin is collateral placed to support potential losses. Notional exposure measures the reference size of the contract and can exceed the margin posted. Initial margin governs opening a position, while maintenance requirements govern whether an existing position can remain open. These rules differ across venues. A one-unit price movement on a large notional can consume a substantial fraction of a small margin balance, which is why percentage returns on margin can look dramatic in both directions.
Profit and loss need a counterparty path
For a simplified linear contract, a long’s price-driven profit is quantity multiplied by the change in reference price, while an equal short has the opposite result before costs. A venue, clearing mechanism or pool must collect and transfer settlement assets. Fees, funding and collateral-price movements can alter the net result. Options have nonlinear payoffs and premiums rather than the same linear exposure. Knowing the formula is only part of understanding whether a winning claim can actually be paid.
Liquidation and reference prices matter
A derivative position may be closed before its holder’s preferred exit if margin falls below requirements. The venue can use a mark or oracle price rather than the most recent trade. Illiquid markets, oracle failures and gap moves can leave losses beyond posted collateral. Insurance funds, loss socialization or automatic deleveraging are possible designs, but their presence and limits are protocol-specific. A derivatives explanation should state the settlement asset, margin system, pricing reference and failure waterfall instead of equating exposure with token ownership.
MAKE IT CONCRETE
Illustrative linear exposure
A one-unit long opened at 100 and closed at 110 gains 10 before costs. If only 20 of margin was posted, that is 50% of the initial margin, even though the underlying price rose 10%.
FAILURE PATHS & COMMON MISREADINGS
Where the model can break
- Notional exposure is not the same as owned assets.
- A stop instruction does not guarantee an execution price through a gap.
KEEP EXPLORING