Futures trading is a type of derivative trading that is highly speculative and allows investors to potentially increase their returns by speculating on the future price movement of digital assets.
Cryptocurrency futures trading allows investors to potentially increase their returns by speculating on the future price movement of digital assets. However, this type of trading can be risky and confusing, especially for inexperienced investors. In this article, we’ll introduce futures trading concepts such as futures contracts and leveraged positions, as well as address associated risks and benefits, to help investors understand cryptocurrency futures trading before diving in.
What is futures trading?
Futures trading is a type of derivative trading, which derives its value from the value of an underlying asset. In the case of futures trading, the investment vehicles are futures contracts. Originally, futures contracts were used to enable commodity producers and buyers to achieve long-term price certainty through a pre-agreed sale price and date. Nowadays, futures are also widely used by investors to wager on an asset’s future price. Trading futures creates an opportunity to profit based on the difference between the price specified in the futures contract and the settlement price when the contract expires.
Futures are contracts that require two parties to buy and sell a particular asset at a specific price, with a pre-determined future date. Whether the buyer or seller makes a profit depends on which way the price of the underlying asset moves — if it goes up, the buyer profits, and if it goes down, the seller profits.
Definition of key futures trading concepts
Futures contracts, also known as futures, are standardized contracts that legally oblige two parties to buy and sell an asset at a specified future date for a predetermined price. Crypto futures contracts can be physically delivered, where the buyer purchases and receives the underlying digital asset, or cash settled, where the two parties settle the contract by transferring cash. Perpetual futures are a particular type of futures contract that have no end date. Rather than settling the contract on a particular date, the two parties to a perpetual futures contract make periodic payments to one another indefinitely.
Leveraged positions are investments made using borrowed capital. Leverage allows investors to establish much larger positions than they would otherwise be able to. The downside of leverage is that it also amplifies losses, which can make it risky when market conditions are volatile and unpredictable. The higher the rate of leverage, the higher the risk an investor’s position could be liquidated.
The expiration date of a futures contract is the date that the contract ends and must be settled. Which side of the contract makes a profit or loss depends on the contract price of the underlying asset relative to the settlement price.
How does crypto futures trading work? An example:
An investor opens a 20x leveraged long (buying) position on a Bitcoin futures contract using $1000 of their own funds – giving them a total position of $20,000. Over the duration of the futures contract, the price of Bitcoin increases 20%. On expiration, the contract is settled, and the investor receives a 20% profit, excluding any fees, totalling $4000.
The difference between spot, margin, and futures trading
Spot trading is simply the purchase of assets at the current market price for immediate delivery. Margin trading allows investors to borrow capital to increase their positions and amplify their profits, but also puts investors at risk of forced liquidation since much of the capital is borrowed. Futures trading obliges investors to purchase or sell the underlying assets at a predetermined time for the price specified in the futures contract.
Benefits of trading crypto futures
With massive leveraging rates available, the biggest advantage of crypto futures trading is the ability to open large positions, and potentially make large profits, with only a small initial outlay. The use of leverage also allows investors to use more flexible strategies to offset risk and minimise losses, such as short-selling, to hedge their other positions.
Another important benefit is that investors can gain indirect exposure to cryptocurrency by investing in futures, meaning they don’t need to hold any cryptocurrency themselves. Users can begin trading crypto futures without the need to create a crypto wallet, store seed phrases, or use other risk management strategies required to safely hold crypto.
Thirdly, trading crypto futures are one of the few ways investors can gain exposure to crypto markets in a regulated environment. When purchased through a regulated futures exchange or futures-backed ETF, investors in crypto futures have access to same legal protections as investors in other products sold through traditional financial markets.
Binance is a highly popular crypto exchange where users can trade futures. You can access more information in our detailed Binance review.
Risks of trading crypto futures
The main risk to investors when trading futures is being forcibly liquidated if an investment goes against them. Being liquidated means that the collateral the investor had put up to open their leveraged position, also known as the initial margin, is taken by the exchange, resulting in a 100% loss on the investment.
The larger the rate of leverage the higher the risk of liquidation. The basic formula for the amount the market needs to move against an investment before it is liquidated is 100/leverage rate. For example, if an investment is leveraged 100 times it would require a movement of only 1% in the wrong direction for the investor’s initial margin to be liquidated.
Before an investor is liquidated, they will typically receive a margin call, which is a notification that their margin account is below the minimum requirement and must be topped up to avoid liquidation. An investor may opt to top up their margin when it has depleted in the hope that the market will soon turn in their favour, but doing so poses the further risk of losing even more capital.
Summary of pros and cons
- Access to high leverage multipliers, potential for larger profits
- Indirect exposure to crypto, more convenient for many investors
- Investing via regulated exchanges and ETFs reduces risk
- Large leverage multipliers means high risk of forced liquidation
- Leveraged futures positions are highly vulnerable to market volatility
- Requirement to maintain minimum margin limits to keep positions open
Speculating on price movement through crypto futures trading lets investors take advantage of high rates of leverage and apply strategies like short-selling. While the potential to magnify gains is appealing, betting on high leverage also carries a higher risk of forced liquidation and losses, especially given the high volatility of crypto markets. Conveniently, investors don’t need to hold crypto to trade cryptocurrency futures, and can benefit from a regulated option by investing in Bitcoin futures backed exchange-traded funds (ETFs).