What Is Crypto Futures Trading and How Does It Work?

Derivatives are financial instruments that provide exposure to underlying assets, such as commodities or digital assets. The value of derivatives is linked to the value of these underlying assets. Cryptocurrency futures are a type of derivative instruments which allows users to access the market without directly buying or selling the underlying spot crypto. Unlike spot trading, futures trading offers the potential for users to capitalize in both rising and falling market conditions.  

Let’s deep dive into what a cryptocurrency futures contract entails, how it works, and its key features.

What Are Crypto Futures?

Futures contracts are a type of contractual agreement between traders to buy or sell an underlying cryptocurrency asset at a predetermined price and date. Simply put, the holder must buy or sell the underlying asset at the agreed-upon date and price.  

Crypto futures typically allow traders and investors to speculate on the cryptocurrency’s potential future price. It enables investors to gain exposure to the crypto market without purchasing the underlying asset. Instead, a futures contract derives its value from the underlying asset and will follow the price movements of this asset. For instance, Bitcoin futures derive their value from Bitcoin.

Futures trading appeals to investors because it allows them to hedge against spot market volatility, diversify their portfolios, use leverage and profit from both downward and upward movement. The trader's positional stance, either long or short, determines the potential for profit or loss in a particular market. For instance, a trader predicting a downward trend can short or sell a futures contract and benefit if the market moves according to their prediction. Consequently, a trader longs or buys a futures contract if they expect the market to rise.

Futures traders often use borrowed funds, called leverage, to amplify their position size and, thus, potential gains. However, this also exposes them to liquidation risks. Liquidation occurs when an incorrect prediction of the crypto futures market's movement leads to the closure of your open position.

How Do Futures Contracts Work?

Think of futures trading as betting on the crypto’s price to either rise or fall, allowing traders to profit from both market directions. That is, traders either open a short position (go short) or a long position (go long).

Traders buy a long futures contract when they anticipate an increase in the value of the asset. This strategy allows them to profit when the underlying asset price rises and incur losses when it falls. On the contrary, they sell a short futures contract when they expect its value to drop. Simply put, shorting allows traders to profit from a decline in the underlying asset’s value.

For example:

Assume that Jojo opens a BTC long position when the underlying asset’s market price is $25,000. At the same time, James, her pessimistic husband, anticipates BTC to dip and opens a short position. If the BTC value rises, say up to $30,000, Jojo gains $5,000 ($30,000 - $25,000 = $5,000) while James loses the same amount. However, if the market goes the other way around and drops to $18,000, Jojo loses $7,000 while James gains $7,000.

Key Features of Crypto Futures Trading

Some of the key aspects of futures trading include leverage, funding rate, and margin.

Leverage

Leverage describes using borrowed funds to control high-value positions with relatively small capital. In other words, it allows traders to magnify their purchasing (or selling) power beyond the limits of their initial capital. While leverage potentially amplifies a trader’s gains, it can also amplify their potential losses due to crypto volatility.

For instance, Jojo or James can open the $25,000 position with only $2,500, which is only a fraction of the cost. The amount of leverage is expressed as a ratio or the number of times the initial deposit is multiplied, such as 1:5 or 5X. In this scenario, James and Jojo use a 10X leverage to open a futures position. It is important to note that liquidation risks increase proportionally with the leverage amount.

Margin

Traders require an initial margin to open a futures position and a maintenance margin to keep it open. Initial margin denotes the minimum amount required to open a trade while maintenance margin is the minimum amount of collateral required to keep the trade open.  

If a trader’s account balance or collateral falls below the maintenance margin, the exchange liquidates their position or sends them a margin call. A margin call refers to the exchange requesting the trader to deposit more funds to their account to meet margin maintenance. Failure to do so leads to liquidation.

In other words, the initial margin is the collateral required to open a leveraged position. For instance, the $2,500 James used to open a BTC short position worth $25,000 with 10X leverage is the initial margin.

Funding rate

Not all futures contracts are bound by expiration and settlement dates. Perpetual contracts are a type of contract that allows traders to continue holding their positions for as long as their margin maintenance remains above the specified threshold.  

Typically, the funding rate is based on the premium and the interest rate. The premium is determined by the price disparity between futures and spot markets while the interest rate varies between exchanges. A positive funding rate means that long contract holders pay short traders, and vice versa.

Closing Remarks

Crypto futures trading allows traders to speculate on market movements. Such flexibility facilitates the potential to realize profits from both downward and upward movements by either going short or long. In addition, it allows investors to hedge against crypto volatility. Yet, it also holds an equivalent potential for losses which at times are maximized with the use of leverage.  

Therefore, it is essential to practice risk management strategies and do your due diligence when engaging with crypto futures.