Cryptocurrencies, like other financial assets, have a derivative market, known as the market for derivative contracts of the cryptocurrencies themselves.
When engaging in direct cryptocurrency transactions, all traded assets are spot assets, meaning traders are actually purchasing the cryptocurrency itself.
However, through the derivative market, there is a way to buy or sell cryptocurrencies without physically owning the underlying assets. One type of contract in the derivative market is the futures contract, which allows traders to profit without possessing the actual cryptocurrency.
How Does Futures Trading Work in Crypto?
Futures trading, or trading futures contracts, is a transaction where a trader buys and sells a contract that reflects the movement of an asset without owning the underlying asset itself.
In the crypto world, futures contracts can mirror the movements of various cryptocurrencies, with each cryptocurrency having its own futures contract. For example, there is a futures contract based on Bitcoin known as Bitcoin futures, and its value or price movement aligns with that of Bitcoin.
These contracts are typically issued by institutions that act as intermediaries for transactions and hold an amount of the cryptocurrency corresponding to the issued contract as collateral.
The need for institutions arises due to the complexity of derivative transactions compared to regular cryptocurrency spot transactions. This complexity allows traders using futures contracts to profit from both rising and falling cryptocurrency prices by buying or selling contracts without actually owning them.
The mechanism is divided into two types of transactions: long and short. Both transactions involve buying the contract, but the key difference lies in how each transaction benefits the contract owner.
Long and Short Positions
To explain the mechanism of these transactions, let’s use the example of Bitcoin futures contracts in this article.
In a long transaction, a trader buys Bitcoin futures contracts when anticipating an increase in the price of Bitcoin. The trader then profits based on the percentage increase in the price of Bitcoin. For instance, if a trader buys $100 worth of Bitcoin futures contracts and Bitcoin rises by 4%, the trader earns a profit of $4.
On the other hand, in a short transaction, the mechanism is different. In this case, a trader buys Bitcoin futures contracts with a short position, anticipating a decrease in the price of Bitcoin. The trader profits when the price of Bitcoin falls. For instance, if a trader buys $100 worth of Bitcoin futures contracts with a short position and Bitcoin drops by 4%, the trader’s profit is $4.
On trading platforms, traders only need to buy and confirm the transaction to purchase futures contracts. However, behind the scenes, the mechanisms are more intricate.
For long transactions, the behind-the-scenes process is relatively straightforward, as traders buy contracts from brokers and sell them when the price rises. For example, a trader buys a Bitcoin futures contract when the price is $40,000 and sells it when the price is $45,000, making a profit of $5,000 from the price movement.
For short transactions, the behind-the-scenes process involves borrowing short contracts from brokers and immediately selling them. Later, when the contract price drops, the trader repurchases the contract to return it to the broker. For instance, a trader borrows a short Bitcoin futures contract when the price is $45,000, sells it immediately, and then buys it back when the price drops to $40,000. The difference in price between selling at $45,000 and buying back at $40,000, $5,000, becomes the trader’s profit.
In futures transactions, traders often use limit orders to ensure risk management, implementing automatic contract buying and selling through limit take-profit and stop-loss orders. Additionally, traders can use limit orders to open positions and simultaneously apply take-profit and stop-loss mechanisms to automatically gain profits or cut losses.
In futures trading, there is a mechanism called leverage, allowing traders to use debt to amplify their transaction positions. Leverage can vary from 5x to 200x, depending on the platform or broker offering futures trading services.
Similar to debt, trading with leverage requires collateral. Therefore, when using leverage, traders must understand the calculation of debt and collateral.
For example, if a trader has a futures trading balance of $1,000 but wants to open a contract position with $100 and uses 5x leverage, the trader will purchase a $500 contract due to the 5x leverage multiplied by $100. Considering the leverage is 5x and the transaction amount is $500, the collateral calculation is the transaction amount divided by the leverage, resulting in collateral of $100, which is the amount used during the transaction.
In this case, the futures trading balance would be reduced to $900, as the initial $1,000 is reduced by $100 for collateral. This $900 is used to maintain the transaction position against potential losses, meaning the maximum loss the trader can handle is $900 before facing a margin call, where the broker takes the collateral and the entire balance in the trader’s futures account due to losses.
Looking at the $500 transaction, the trader would need to incur a loss of 180% to reach a $900 loss. This mechanism may seem normal with low leverage, but with high leverage, the risks also increase.
For instance, if a trader has a $1,000 balance but uses 200x leverage with $100 collateral, the transaction position would be $20,000, exceeding the balance. If the trader only has $900 remaining and holds a $20,000 transaction position, a loss of 4.5% would trigger a margin call, resulting in a smaller tolerance for losses.
In this leverage mechanism, traders must be cautious, as leverage can provide both profits and losses for traders in the long run.
Types of Futures Contracts
To understand the details of futures contracts, traders must realize that there are several types of contracts traded, especially in the crypto market.
There are two main contract types: traditional futures contracts and perpetual futures contracts. Both contract types also have two types of collateral mechanisms: collateral in fiat and collateral in crypto.
In traditional futures contracts, the contracts have an expiration date, requiring traders to liquidate their positions in profit or loss according to the expiration time. A common example is monthly-expiring futures contracts, where traders must sell and close their positions at the end of each month, regardless of whether they are in profit or loss.
On the other hand, perpetual contracts do not have an expiration date, allowing traders to keep their positions without worrying about expiration until they are satisfied with the transaction position. Perpetual futures contracts are commonly used by retail traders, especially if their capital is relatively small.
Aside from these two types, traders need to understand that there are contracts using collateral in fiat and in crypto. When intending to buy futures contracts, ensure that the available funds match the contract, as fiat-based futures contracts can only be bought with fiat such as USDT, and crypto-based futures contracts, like Bitcoin, can only be bought with Bitcoin.
It’s important to note that both of these assets are still based on specific cryptocurrencies. For example, if a purchase is made with fiat, the price movement of the contract is still based on the specific cryptocurrency used.
For instance, a trader can choose a perpetual Bitcoin futures contract with a long position and purchase the contract with fiat collateral, eliminating the need to buy in the form of Bitcoin.
Of course, there are many other aspects to consider, especially in analysis and risk management when trading futures. This article serves as an introductory guide to provide an initial overview of what futures transactions, especially in the crypto market, entail.