What are crypto futures contracts?
Understanding crypto futures trading
Cryptocurrency futures trading has gained significant popularity since investors are finding out how to gain profits on the evolving crypto market. It is used as an investment strategy that provides price discovery, increased market liquidity and serves as a risk management tool.
Futures refer to a type of derivative trading product and present trading contracts between two parties to purchase or sell an underlying asset at a fixed price on a certain date. Within traditional financial systems, some of the most traded types of futures are financial futures such as contracts that trade in the future value of a security or index, currency futures as well as metal, energy and agricultural futures.
Therefore, the underlying asset of traditional futures contracts are often commodities; banks initially created this type of financial contract to enable farmers to lock in prices for their produce at a future date.
When it comes to the crypto market, trading crypto futures such as Bitcoin futures and Ether futures involves entering into agreements to buy or sell these underlying assets at a predetermined price and date. For example, in the case of Bitcoin futures contracts, the underlying asset is Bitcoin (BTC).
Investors mainly use futures contracts to hedge against market volatility and ensure they can trade a particular asset at a set price.
What is the difference between futures markets and spot markets?
Trading in spot markets means that an asset is traded at its current market price as traders exchange one asset for another asset. For example, a trader exchanges USDT for BTC. This method of settlement refers to immediate delivery since assets are transferred at the point of sale.
In the futures market, traders agree to settle their contractual obligations at a predetermined future date.
There are two main differences between spot and futures trading on the crypto market. The first difference refers to exposure; spot trading amounts to direct exposure to the market by holding the underlying asset in a crypto wallet. Futures trading on the cryptocurrency market provides traders with indirect exposure to price fluctuations without the need to hold the crypto asset itself.
Secondly, futures traders are provided access to leverage. In simple terms, futures traders can open larger positions using a small initial deposit which is typically known as initial margin.
What is the difference between futures contracts and option contracts?
Similar to crypto futures contracts, options contracts are tied to the underlying asset. Options refer to derivatives that enable traders to purchase or sell the underlying asset at a predetermined price on a future date.
However, the main difference between these two financial contracts is that crypto options provide the trader with the right but not the requirement to purchase or sell the crypto asset. To gain this right, the buyer typically pays an upfront fee to the option writer which is known as the premium.
What are crypto futures contracts?
As explained above, crypto futures contracts present standardised agreements between two parties to buy and sell an underlying asset at a predefined price on a specified date in the future. Within the crypto space, such contracts enable investors to trade Bitcoin futures, Ether futures, and other cryptocurrencies with the main goal of managing risk associated with price movements.
Crypto futures trading is based on the concept of strategy and prediction. For example, if you think that Bitcoin’s price will increase, you can enter a long position by purchasing a Bitcoin futures contract.
When a trader buys a futures contract, they profit when the contract price rises which happens when the underlying asset's price increases. On the other hand, when a trader sells a futures contract, they profit when the contract price falls which is associated with the downtrend of the underlying asset.
The main components of a crypto futures contract
A futures contract is made of several components as it must indicate the nature of the agreements. Let’s check out the futures contract’s key terms.
The underlying asset and contract size
Futures can be traded on a wide range of financial markets such as stocks, commodities, and cryptocurrency markets. The contract size specifies the amount of the underlying asset to be delivered. For example, in a crude oil futures contract, the contract size could be determined in barrels of crude oil.
Crypto futures agreements' size can vary depending on the form. Typically, Bitcoin futures contracts equal 5 BTC while micro futures contracts may have a lower value than 5 BTC.
Price and position limits
Exchanges typically demand limits on daily price movements of futures. Limit ups and limit downs presents the maximum amounts a futures contract may increase or decrease in a single trading day.
Position limits refer to the maximum number of contracts that a market participant can hold, and they differ between exchanges.
Settlement method
A futures contract can be settled in two ways – by physical delivery or by transferring cash positions. As the name suggests, physical delivery refers to the actual asset being delivered upon the determined delivery date, while the cash settlement procedure refers to transferring the associated position. A futures contract usually determines where and when the parties must settle the contract.
Minimum price fluctuation
Crypto futures contracts include a minimum price fluctuation which is also known as a tick and refers to the minimum increase of price movement which is possible in futures contract trading. Tick movements can impact the profit and loss as well as the volatility of the trader’s futures position.
For example, a Bitcoin futures contract has a minimum tick size which equals $5. If you multiply the tick size by the size of the contract, you get the dollar value of a one-tick move. Therefore, in a Bitcoin futures contract with a minimum tick size of $5, the value of a one-tick move equals $25.
Expiration date
Futures contracts include a limited lifespan that impacts the outcome of the trade and the exit strategy. A contract’s expiration date refers to the last date on which the contract can be traded. It usually happens on the third Friday of the expiration month, but it can vary by contract.
Main types of crypto futures contracts
Crypto futures trading involves two types of contracts – physically settled and cash-settled contracts. Let’s explain them briefly.
Physically settled crypto futures
Physically settled crypto futures contracts include the delivery of the underlying crypto asset when the contract expires. It refers to a usual method of derivatives settlement methods; a futures contract is, for example, settled by a short position holder or the seller by the delivery of the actual product, and the long position holder as the buyer provides the counter asset, typically a fiat currency.
Cash-settled crypto futures
Cash-settled crypto futures contracts are about the exchange of cash equivalent to the crypto asset’s value at the time of the contract expiration. In other words, both the seller and the buyer transfer cash based on the price of cryptocurrency at the time of settlement. Cash-settled crypto futures contracts are typically used by investors that want to speculate on the future price of crypto assets without owning it.
What is the lifespan of a crypto futures contract?
Futures contracts are known to expire on a particular date, and the trader needs to deal with futures expiration. There are three choices a trader can make when a future contract expires – offset the position or liquidate, roll over a crypto futures contract, or settle it.
The most common way to exit a trade can be done through offsetting or liquidating a position before the contract expires. Offsetting a position means that a trader is implementing an equal and opposite transaction to neutralise the trade. Final delivery can also be avoided by ending the contract before the futures contract expires.
Secondly, a trader can roll the futures contract forward, meaning that the trader simultaneously offsets their current position and establishes a new one in the next contract month.
Finally, the contract can expire and settle. The party with the short position needs to deliver the underlying asset under the specified settlement method.
A Bitcoin futures contract example
The Bitcoin futures market is subject to evolving regulatory landscapes across divergent jurisdictions. Regulated exchanges typically provide a compliant environment for crypto futures trading. For example, the CME Group in the United States has been established by the Commodity Futures Trading Commission (CFTC).
Analysing the CME Group’s contract specifications, we can see first that the contract unit equals 5 Bitcoins and that the price quotation is expressed in U.S. dollars and cents. Secondly, the contract specifies trading hours and minimum price fluctuations of $5 per Bitcoin and $25 per contract as well as the settlement procedure, position limits, and expiration date.
The underlying asset of a Bitcoin futures contract is based on the price of Bitcoin. A futures contract is a derivatives feature, meaning that it presents a contract that derives value from an underlying asset and not by itself. A Bitcoin futures contract has value because it is backed by Bitcoins maintained by the exchange issuing such contracts. Therefore, it is a derivative product.
At any point in time in the market there are two parties – one party wants to go short on the crypto asset due to thinking that it will lose value in the future, and the other party wants to go long on the asset believing it will gain value. They open a Bitcoin futures contract with two positions – a long position and a short position. A valid futures contract includes one person buying it and one person selling the asset at the same time to close both positions.
Main purposes of crypto futures
Crypto traders utilise various trading strategies to navigate the crypto landscape efficiently. Crypto futures trading includes three main purposes that cater to divergent objectives and risk tolerance.
Hedging
Hedging can be defined as a risk management tool used to reduce the risk of existing portfolio positions in the crypto sphere. Traders employ futures contracts to counterbalance potential losses in the crypto market and secure their investments from price volatility.
Using crypto futures contracts for the purpose of hedging provides the potential to hedge at a fraction of the portfolio’s value which provides an additional layer of protection for the investment.
Arbitrage
Arbitrage presents a trading strategy that is based on finding price discrepancies between divergent markets and contracts to produce profits with a lower level of risk. Traders tend to purchase a cryptocurrency on one exchange that has a lower price and then sell it on another exchange with a higher price.
Crypto futures arbitrage strategies such as day trading, cross-exchange arbitrage, and triangular arbitrage, are often used by crypto traders.
In some cases, a trader can gain profits by shorting and longing the same underlying asset on two divergent futures exchanges. This is possible only if two futures contracts on different exchanges track prices in a similar manner, provide the same leverage and a similar settlement date.
Speculation
Speculation is based on taking positions in futures contracts based on expected price movements to gain profits. This strategy capitalises on price volatility and amounts to crypto traders making speculative moves based on market predictions and the likelihood of a crypto asset’s value increasing.
Futures provide traders with the opportunity to to speculate on future prices of certain crypto assets and take advantage of price swings. For example, opening a short position on a futures contract is a simple way to gain profits if the underlying asset’s price goes down.
Speculators engage in price changes and extract profit from fluctuations. To learn more about speculation in the crypto world, check out this article: 'Does crypto need speculation? Why crypto bettors aren't all that bad'.
The main advantages of cryptocurrency futures contracts
If you want to trade cryptocurrency futures, you will read about its many benefits. Since they provide certain regulated access to cryptocurrency, users feel more confident to try it out as well as institutional investors that compose the majority of trades in crypto futures contracts.
Let's take a look at the main upper-hands of crypto futures contracts.
Simplicity of investing in cryptocurrencies
Crypto futures trading simplifies investing as you don’t need to put funds for storage or trading. It offers a strategy to just invest in crypto assets without the need to store them accordingly.
Speaking of investing, crypto futures can be used by long-term investors in the crypto space to mitigate downside risks by taking up opposite positions in the futures contracts against their holdings as well.
Position limits
Crypto futures include position and price limits that provide traders with the possibility to reduce their risk exposure. They are deemed a safer way to get into crypto without getting burnt.
Keep in mind that position limits differ between exchanges. However, leverage is the most attractive feature of crypto futures as it presents an ability to control a broad contract value that stems from the underlying asset with a limited amount of capital.
Potential tax benefits
A lesser-known advantage of crypto futures is linked to tax benefits. When trading crypto futures, you need to pay taxes on capital gains just like you would pay when trading equities. However, regulated futures trading profits are taxed in the United States on a 60/40 rule, meaning that 60% of capital gains are taxed as long-term gains and 40% are taxed as short-term gains.
Don't take this as financial advice and keep in mind that tax laws differ from one country to another. Always do your due diligence and learn about tax laws in your country.
Risks associated with futures contracts
Even though crypto futures trading encompasses several benefits, it also includes a number of risks associated with it that investors should be mindful of. New users may lack the necessary knowledge and expertise to navigate the complexities of futures trading effectively.
To understand the crypto futures market, you need to obtain a substantial level of technical and financial knowledge of the crypto sphere. We suggest checking out courses at our Learn Crypto Academy.
Now, let’s delve deeper into the risks of crypto futures contracts.
Margin requirements and counterparty risk
When you trade with leverage you borrow funds from a third party which is usually the exchange you are trading with. Exchanges typically won’t let you borrow funds without giving them a sort of insurance if the trade goes against you. This insurance is known as the initial margin; you need to set the initial margin aside before opening a trade.
For example, margin requirements for Bitcoin futures differ depending on the exchange or platform. Additionally, brokerages can set out their margin rates for Bitcoin futures trading.
A potential risk to the counterparty happens when one party fails to fulfil a contractual obligation stated by the contract. In terms of crypto futures contracts, this can result in a loss by the broker or exchange and could affect the trader's performance.
Regulatory issues
Crypto futures can be traded on both regulated and unregulated exchanges. Regulatory issues revolving around the crypto space and crypto futures trading can influence market stability and the availability of trading options.
Market volatility
Market volatility can produce rapid price movements which makes it difficult for traders to maintain an effective risk management strategy. A wide array of factors can contribute to the crypto market’s volatility such as regulatory concerns, market sentiment, and speculation.
Traders can mitigate these risks by constantly employing measures, using leverage carefully and diversifying their portfolios. Trading futures includes a clear understanding of market dynamics.