What are inverse futures contracts in crypto?
Understanding crypto inverse futures contracts
Futures contracts refer to a type of derivative trading product and present contracts between two parties to purchase or sell an asset. The underlying asset's price is fixed on a certain date. Futures contracts are used as an investment strategy that adds up to price discovery, market liquidity and helps with risk management.
To ace the basics of futures contracts, why not read this article: 'What are crypto futures contracts?'.
Now that we have explained a bit the meaning of futures contracts, let's get down to their inverse counterpart.
The definition of an inverse futures contract goes like this: an inverse futures contract refers to a financial agreement that requires the seller to pay the buyer the difference between the agreed price and the current price upon the contract’s expiration date. In other words, the seller should benefit from the price decline.
Let’s simplify this- you probably wonder why are these contracts called inverse? In contrast to regular futures contracts which are usually settled in U.S. dollars, a fiat currency, inverse futures contracts are settled in cryptocurrency.
Therefore, when you enter an inverse contract, you agree to buy or sell a certain amount of cryptocurrency at a predetermined price at a future date. Instead of being calculated and paid in a fiat currency such as the U.S. dollar, the profit or loss is paid out in cryptocurrency.
Before moving on with inverse futures contracts in the crypto space, keep in mind that education is very important when dealing with crypto assets. To efficiently navigate the financial markets and digital assets, we suggest taking a look at available courses at our Learn Crypto Academy.
Types of crypto futures contracts
With the cryptocurrency market becoming more mature, futures contracts, a concept that stems from traditional finance, is becoming essential for seasoned traders that want to capitalise on price fluctuations.
Main types of crypto futures contracts are perpetual, inverse and linear futures contracts. Each of them comes with a different set of features. More experienced crypto traders understand the need to know all their differences and potential applications to enhance their trading strategies accordingly.
Aside from these main types, there are also so-called quanto futures contracts, cash-settled, physically settled, leveraged, spread, vanilla and basket futures contracts.
If you wonder where you can trade futures contracts, take a look at this article: 'Where to trade futures in 2024?'.
What is the difference between inverse and linear futures contracts?
In a liner futures contract, the trader uses and earns the same currency. If there is a Bitcoin contract priced in U.S. dollars, the profit/loss and the margin are in the same currency.
Linear futures contracts are also usually settled in a stablecoin, such as USDT, while inverse futures contracts are always settled in the underlying cryptocurrency, such as Bitcoin or Ethereum.
Linear futures contracts value the profit/loss and margin in the quotation currency, which is also known as a vanilla contract. Thereby, a futures contract in Bitcoin valued in U.S. dollars is margined and settled in that currency. A vanilla futures contract presents one of the most basic forms of futures contracts where users are allowed to speculate on the asset's future price without owning the asset.
How does an inverse futures contract work?
As the name suggests, inverse contracts are non-linear. For example, if a trader goes long on the BTC/USD inverse futures contract, they are shorting the U.S. dollar; since the futures contract is inverse, a higher value of Bitcoin increases in relation to the U.S. dollar.
In contrast to ordinary futures contracts where traders agree to buy or sell an asset at a predetermined price on a future date, inverse futures are different. Unlike traditional futures contracts, the seller profits when prices decline.
Let’s look at the mechanics using the Bitcoin example- think of a Bitcoin inverse futures contract with a price of $5000 per contract. This number doesn’t represent the future price, but the difference between the current price and the settlement price on the contract expiry.
So, how do traders profit then? Imagine now the actual price of Bitcoin falling to $3000 by expiry; the inverse contract shows a $2000 difference in the trader’s favour because the contract price remained at $5000, yet the underlying asset’s price went down. The contract settles, and the traders get the $2000 difference. However, if the price of the underlying asset goes up $2000, the trader experiences a loss.
Basically, inverse futures contracts enable traders to profit when the price of the underlying asset goes down. Keep in mind that the contract price only shows the difference between the current price and the settlement price.
Understanding the futures contracts' pricing structure
The pricing mechanics of crypto futures contracts in general is based on two main theories- the Cost of Carry Model and the Expectations Theory.
The first theory known as the Cost of Carry model states that the futures price is established by the spot price of the underlying asset with the addition of the cost to carry or hold until the contract’s expiration date. For example, the cost to carry or hold includes interest rates or storage costs.
The Expectations Theory suggests that futures prices reflect market expectations of the underlying asset’s price.
For traders that want to engage in futures contracts trading, it is essential to be aware of certain factors that can affect the prices to facilitate better financial planning. In addition to the spot price of the underlying asset which serves as a foundation for futures pricing, they need to consider interest rates, supply and demand dynamics, time to expiry, and high volatility in the crypto market.
Advantages of inverse futures contracts
Inverse future contracts are mainly used to achieve higher profits, reinvest funds into cryptocurrencies and implemented as hedging instruments without the need to convert funds into fiat currencies. Here are some main upper-hands of these futures contracts.
Hedging against market volatility
With inverse futures contracts, users get the chance to hedge their funds and protect themselves from possible financial losses. This strategy is like an insurance policy for crypto assets which improves risk management techniques of futures trading.
However, hedging requires a deeper understanding of the underlying market and assets involved. It is a smart move for those traders that have enough knowledge and proceed with caution.
Speculation-friendly
Even though speculation can also be a downside of inverse futures contracts, sometimes it is not a bad thing in the crypto space. Traders can use inverse futures contracts for speculative purposes and capitalise on predicted price declines.
Speculation provides a higher degree of flexibility, and the ability to profit from both bullish and bearish market conditions. Since inverse futures contracts enable traders to profit from declining prices of the underlying crypto assets, traders get the chance to also capitalise on market corrections or downturns.
To find out more about speculation, take a look at this article: 'Does crypto need speculation? Why crypto bettors aren't all that bad'.
Market effectiveness
Since inverse contracts futures add up to the overall market effectiveness by providing liquidity and price discovery systems, they amount also to price stability and diminish arbitrage opportunities between divergent crypto exchanges.
Additionally, inverse futures contracts support leverage and enable traders to control bigger positions with smaller upfront investments. Although this can help in gaining bigger profits, traders could increase their risks as well.
Disadvantages of inverse futures contracts
While experienced traders, who understand market dynamics well, think of inverse contracts as good tools to capitalise on price movements, they bring to the table several risks everyone should be aware of.
Let's take a look at the bad side of inverse futures contracts.
The possibility of amplified losses
The crypto market is susceptible to changes; market volatility can boost both profits and losses.
If the underlying asset’s price moves against the trader’s position, losses can be bigger than expected. In times of high market volatility, price movements can be quick and not easy to anticipate.
Similar to other markets and traditional futures, crypto futures markets can sometimes be affected by regulatory developments or macroeconomic events. Traders should always stay informed about events that could affect the market prices.
Complexity
An inverse futures contract is not a suitable trading strategy for everyone. We have already highlighted the fact that it requires knowledge and experience as well as caution. Inverse futures contracts might not be beginner-friendly.
In other words, managing inverse futures contracts calls for a solid understanding of derivative trading strategies and market dynamics. The inverse nature adds complexity compared to a linear futures contract. A lack of knowledge can lead to errors.
Leverage risks
Inverse futures contracts typically support leverage, enabling traders to control bigger positions with smaller upfront investments. Leverage can amplify profits, but it also brings to the table the possibility of major financial losses.
Additionally, trading on leverage means that traders might face margin calls if the market moves in an unfavourable direction. In this case, traders need to put in more capital to maintain their positions or experience losses at unfavourable market prices.
Counterparty and liquidity risks
Inverse futures contract trading is usually done through crypto exchanges or trading platforms. There is always a risk that an exchange or platform might fail to fulfil its obligations or become bankrupt. The counterparty risk means that traders could end in losing their funds.
On the other hand, when there are not favourable market conditions or the market experiences low trading activity, the liquidity can go down as well. Lower levels of liquidity can result in greater slippage which might affect the overall profitability of inverse futures contracts trading.
The market impact of crypto inverse futures contracts
Keep in mind that nothing in this article is intended as or shall be understood as financial advice. When dealing with financial markets, either traditional or crypto, it is important to demonstrate a high level of financial responsibility and do your research as well as consult a professional.
It is already obvious that cryptocurrencies are here to stay, for better or worse. While it might seem that it takes years to reach mainstream adoption, they have introduced interesting contrasts to products and concepts that stem from traditional finance and incorporated them into a new financial system based on blockchain technology and decentralisation.
A part of the community thinks, in addition to several financial experts, that for cryptocurrencies to gain a real mainstream adoption, it must become a norm.
Products such as futures contracts and all its subtypes are products that have the potential to open crypto trading to traders that are still standing outside this digital realm.
It must be noted that products such as U.S. dollar pegged stablecoins and similar products helped in attracting traders and investors by providing a familiar pathway to decentralised financial alternatives.
As mentioned several times above, a derivative product trading strategy must be based on a deep comprehension of the underlying market and trading knowledge. In the crypto world, education and the possibility to conduct thorough research are very important.
Financial stress and market volatility are often seen within the crypto market. However, crypto assets are not exempt from the effect of macroeconomic events, even though its performance is typically driven by factors such as market sentiment and technological innovations.
As more institutional investors turn to crypto, which is good for mainstream adoption, the crypto market's relationship with macroeconomic factors could become stronger, and the new financial system could bring up more concepts from traditional finance.
Inverse futures contracts are a good tool for your crypto trading operations but make sure you are educated and informed enough before giving it a go.