Crypto Futures: Everything to Know
By Beluga Research September 5, 2023
- Crypto futures are financial contracts that enable traders to speculate on the future price movements of digital assets
- Futures allow parties to buy or sell a specific quantity of cryptocurrency at a predetermined price on a future date
- Traders can use crypto futures to hedge positions, manage risk and potentially generate profits through speculative trading strategies
- Crypto futures have unique aspects such as the ability to profit from both rising and falling markets and the option to hedge positions in the spot market
"Crypto futures" are financial contracts that enable traders to speculate on the future price movements of digital assets. Unlike "spot trading," wherein assets are bought and sold for immediate delivery, futures contracts enable traders to enter into agreements to buy or sell a specific amount of a cryptocurrency at a predetermined price and date in the future.
This financial instrument provides opportunities for both hedging against price fluctuations and seeking profit through speculative trading. Crypto futures markets have gained popularity due to the potential for significant gains, but also carry higher risks due to leverage.
A Brief History
Futures contracts have a long history in traditional commodity trading, but crypto futures are a more recent development. The first bitcoin futures contract was launched by the Chicago Board Options Exchange (CBOE) in December 2017, followed by the Chicago Mercantile Exchange (CME). These milestones helped legitimize cryptocurrencies as financial assets and opened the door for institutional investors.
Crypto Futures: Everything to Know
- Market Participants . Crypto futures attract individual traders, institutional investors and miners, each with different motivations such as seeking profit, managing risk or hedging existing crypto holdings.
- Margin Trading . Crypto futures allow "margin trading," which lets traders borrow funds to increase trading positions. While this can amplify profits, it also magnifies losses, so caution and understanding of the risks are necessary.
- Leverage . Leverage allows traders to control larger positions with less capital. Crypto futures often offer high leverage ratios, increasing potential gains but also exposing traders to greater risks, including losses exceeding the initial investment.
- Long and Short Positions . Traders can take long positions by buying futures contracts with the expectation of price increases, or short positions by selling contracts with the anticipation of price declines. This ability to profit from falling markets is unique to crypto futures.
- Settlement Types . Crypto futures have two settlement types: physical delivery and cash settlement. Physical delivery involves transferring the underlying cryptocurrency upon contract expiration, while cash settlement settles the contract's value in cash. The settlement type depends on the exchange and the specific contract.
- Price Discovery . The trading of crypto futures contributes to price discovery in the underlying cryptocurrency markets. As futures contracts are bought and sold based on anticipated future prices, this information influences spot market prices and provides insights into market sentiment.
- Risk Management . Effective risk management is crucial when trading crypto futures. Traders should understand risk tolerance, use appropriate position sizing and employ risk management tools like stop-loss orders. Staying updated on market news, monitoring liquidity and understanding contract specifications are also essential.
To trade crypto futures, individuals need to first sign up with a cryptocurrency exchange that supports futures trading. These exchanges facilitate the trading of standardized futures contracts, which are agreements between two parties to buy or sell a specific amount of a cryptocurrency at a predetermined price and time in the future.
Once registered, traders can choose from a range of available cryptocurrency futures contracts, representing popular cryptocurrencies like bitcoin (BTC), ether (ETH) or XRP (XRP). Traders can take a "long position," which involves buying the contract in anticipation of price appreciation or a "short position," which means selling the contract with the expectation of price decline.
Leverage is an important concept in crypto futures trading. It allows traders to open positions that are larger than the account balance, potentially amplifying both profits and losses. For example, with 10x leverage, a trader can control ten times the value of the account balance. While leverage can enhance gains, it also increases the risk, as losses can exceed the initial investment. Traders must exercise caution and manage risk appropriately when using leverage.
Crypto futures have several unique aspects compared to traditional futures contracts. One key distinction is that cryptocurrency markets are available twenty-four hours per day, seven days per week, unlike traditional stock or commodity futures. This constant availability allows traders to react to market developments and news regardless of location or time zone.
Another notable aspect is the ability to profit from both rising and falling markets. In traditional markets, short selling can be challenging, but in the crypto futures market, traders can easily take short positions, potentially profiting from declining cryptocurrency prices. This flexibility expands the range of trading strategies available to market participants.
Furthermore, crypto futures allow traders to hedge positions in the spot market. Hedging involves taking offsetting positions to mitigate the risk of adverse price movements. For example, if a trader holds a significant amount of bitcoin and is concerned about a potential price decline, they can open a short position in bitcoin futures. If the spot price of bitcoin drops, the losses incurred in the spot market can be offset by the gains in the futures market, protecting the trader's overall portfolio value.
- Leverage . Trading cryptocurrency futures allows traders to control a larger position with less capital using leverage. While leverage can amplify profits if the market moves favorably, it also increases the risk of losses.
- Speculation . Crypto futures enable traders to speculate on the price movements of cryptocurrencies without owning the underlying asset. Traders can profit from both rising and falling markets by correctly predicting the direction of price movement.
- Hedging . Cryptocurrency futures can be used for hedging purposes. Traders can take a futures position to offset potential losses in another investment. For example, if a trader holds bitcoin and expects a price decline, they can enter a short futures position to hedge against that risk.
- Liquidity . Cryptocurrency futures markets are highly liquid, allowing traders to enter and exit positions quickly at competitive prices. High liquidity reduces the risk of "slippage," where the execution price deviates from the expected price due to a lack of market liquidity.
- Diverse Trading Options . Crypto futures markets offer various cryptocurrencies and contract durations, allowing traders to tailor strategies to specific preferences and risk tolerance.
- Volatility . While volatility can be advantageous, it also poses a significant risk when trading cryptocurrency futures. The price of cryptocurrencies can be highly volatile, leading to substantial gains or losses in a short period. Traders must have a well-defined risk management strategy.
- Complexity . Cryptocurrency futures are more complex compared to traditional financial markets. Traders need a deep understanding of the underlying technology and market dynamics, including concepts like margin requirements, contract specifications, and funding rates. Decentralized markets introduce unique challenges.
- Counterparty Risk . Trading cryptocurrency futures exposes traders to counterparty risk, the possibility that the other party may default on obligations. Traders should consider the reputation and reliability of the exchange or platform they use.
- Regulatory Uncertainty . The regulatory landscape for cryptocurrencies and cryptocurrency derivatives is evolving. Different jurisdictions have varying rules, and new regulations can impact the trading of cryptocurrency futures. Traders need to stay informed and comply with legal requirements.
- Price Manipulation . Cryptocurrency markets have faced allegations of price manipulation. While efforts are being made to improve market integrity, the decentralized and relatively unregulated nature of the cryptocurrency ecosystem can make it susceptible to manipulation. Traders should exercise caution and due diligence.