In this article, we will explain what cryptocurrency futures are and how they work. Next, we’ll take a more practical look at its usefulness and all the basic things you need to know about futures trading.
A cryptocurrency futures contract is a legal agreement to buy or sell a financial asset on a specific date and at a predetermined price. In this case, the underlying asset on which the contract is concluded is a cryptocurrency such as Bitcoin, Ethereum or Cardano.
Futures contracts explained
Futures contracts are a type of financial derivatives that allow you to speculate on the price movements of assets such as commodities, stock indices or cryptocurrencies.
Basically, this allows you to be exposed to price fluctuations of an asset, whether it goes up or down, but without having to own it.
For example, in the case of Bitcoin, by buying a futures contract, we can benefit from its price increase, but without having to buy and store Bitcoins in our wallet.
However, before starting to speculate on futures contracts, it is necessary to understand how they work because these contracts involve a number of rights and obligations.
The buyer of a futures contract assumes the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract undertakes to supply and deliver the underlying on the expiry date.
In the example above, the underlying asset is Bitcoin. If we buy a futures contract and the expiry date arrives, the contract will be liquidated and we will receive the corresponding amount of Bitcoins at the price at which we bought the contract.
Explained with simple numbers and in a very simplified way:
- In March 2022, I bought a Bitcoin futures contract with an expiration date of June 2022 at a price of $36,000.
- Upon reaching June 2022, the contract is settled, so it gives us the agreed Bitcoin.
- If the June Bitcoin price is $38,000, because we pay $36,000 for the contract, we have made a profit of $2,000.
Futures contracts are standardized, that is, they precisely define the terms and conditions and the factors that may affect their use in order to facilitate their trading on the futures market.
This way, we can buy and sell futures through a cryptocurrency exchange or broker, just like we would with cryptocurrency. However, with the above, I am only referring to the specific act of buying and selling, as this is a complex financial product, so there are quite a few important things to know before you trade futures contracts.
What are the benefits of cryptocurrency futures trading?
Futures contracts are used by crypto traders and investors for a variety of reasons.
First, futures contracts allow you to be exposed to the movements of a cryptocurrency without having to own it. Instead of directly buying a cryptocurrency like Ethereum, which means we have to protect it ourselves, we can use the futures market to earn potential profits from its movements without having to buy it.
Additionally, cryptocurrency futures allow you to open long and short trades, which means we can speculate on price movements if the market goes up or down.
Finally, futures contracts also allow investors who hold cryptocurrencies to hedge to reduce risk if the price drops.
This is done by taking a short entry into the futures contracts of the same cryptocurrency in which we are invested. If the price drops, the short position will mitigate the losses of the cryptocurrency we are investing in due to the additional profits made with the futures position.
How futures contracts work
Cryptocurrency futures contracts have three main things to know:
- Expiration date: This is the date when the contract must be settled, i.e. one party must buy and the other must sell at the fixed price. But it is important to know that you can sell the contracts before the settlement date.
- Units under contract: this is the number of units of the underlying asset that each contract is equivalent to. For example, one CME Bitcoin futures contract is equivalent to 5 bitcoins.
- The sink: futures contracts allow us to open positions with less money in the account than if we were doing it in cash (we need 100%). This way we can increase the size of our trades according to the leverage allowed in each trade.
Types of Crypto Futures
There are several types of futures contracts. Knowing them is important because thanks to some of them we can trade easily, greatly simplifying everything we initially discussed regarding expiry dates and regulations.
Settlement of Futures Contracts
The two different ways in which futures contracts are settled are:
- “Physical” settlement: when the contract is settled, the buyer buys and receives the cryptocurrency at the agreed price.
- Cash settlement: At the time of settlement, there is a cash transfer between buyer and seller. In other words, if the contract price at expiration is $36,000, this is the amount credited to your account in exchange for that contract.
Difference Between Futures and Perpetual Contracts
If you have been trading cryptocurrencies for some time, you may have heard the term «perpetual swaps», commonly known by their English name Perpetual swaps or «Perps».
Perps work very similarly to futures contracts in that they allow an investor to buy or sell an underlying asset, but with the difference that perpetual contracts do not have an expiration date. .
This means the trader can keep their contract open for as long as they want until they decide to close the position as long as they meet certain margin requirements i.e. they have a certain amount of money in his account as collateral.
Where can I trade cryptocurrency futures
To trade futures, we have two options: we do it through the regulated futures market or we operate through a cryptocurrency exchange that offers this type of financial product.
Each has its pros and cons, so we’ll look at them separately.
Regulated futures market
In this group we will find futures contracts regulated by authorities such as the CFTC (Commodity Futures Trading Commission) in the United States.
Currently, the most widely used regulated crypto futures are CME, CBOE, and BAKKT. The main issue is that they only have Bitcoin futures available, and being more focused on institutional investors, the capital requirements to operate are high.
To access these futures, you must do so through traditional brokers such as Interactive Brokers.
cryptocurrency exchanges
Centralized exchanges were the first to offer users the ability to trade futures contracts and are commonly used by traders focusing on cryptocurrency trading.
The main advantage is that they allow trading perpetual contracts of a wide range of cryptocurrencies and not just Bitcoin as it happens on regulated markets.
It is important to note that they allow very high leverage, this feature being a double edged sword as we will see in the next section.
Some of the biggest exchanges with the highest volume of futures trading are Binance, FTX, and Kraken.
Important considerations to know
Despite the advantages of futures trading over spot market execution (direct buying and selling of cryptocurrencies), there are certain risks mainly related to leverage.
Leveraged trading allows you to open larger positions with less money needed to do so. Leverages of 5x, 10x or 20x are quite common, but this implies that the funds are provided by third parties (usually the Exchange takes care of this).
In order for them to lend you these funds, you must adhere to a number of safeguards in case the position moves against you and you suffer losses. For this reason, before opening a trade, you must deposit an amount called «initial margin» which will cover possible losses.
If we are in a trade and the market moves against us, the originally deposited margin begins to decrease. If we don’t add more funds and eventually the margin account reaches zero, what is called a «wind-up» occurs. This means that the entire position will be automatically closed by the exchange and the initial margin you had will be taken in full.
To summarize the idea a bit, if we use very high leverage, small price movements mean very large movements in our account. Being a very volatile cryptocurrency market means that the risk of being liquidated and losing your invested capital is very high.
CONCLUSION
Futures contracts allow us to speculate on the price movements of cryptocurrencies without having to own them, either up or down.
Exchanges make it easy to trade futures contracts because there are a wide variety of perpetual contracts on different cryptocurrencies.
But we must never forget that we are using a high-risk financial asset. We have to be careful with any transaction, because the high leverage allowed, added to the high volatility of cryptocurrencies, can play tricks on us.