What Are Futures?
In simplest terms, futures are a financial contract wherein two parties agree on the price of an asset in the future. For example, we both agree that I will pay you $10,000 next week for one Bitcoin, even if it’s price by then is at $20,000 — because it could just as easily be at $4,000.
In fancier terms, futures are a form of financial derivative contracts that creates an obligation for two parties to trade the underlying asset for an agreed-upon price at a predetermined time (date of expiry). At expiry, the buyer is obligated to buy the underlying asset from the seller at their trade price, and the price of the underlying at expiry is irrelevant.
This makes futures contracts extremely effective for hedging future price risk, as parties can lock in a suitable price in advance of delivery. This means that miners can estimate how much Bitcoin they could potentially mine in the future and sell the futures contract in anticipation of their output. This allows them to capture favorable prices for the Bitcoin, which they have not yet mined.
What Are Cryptocurrency Futures?
The “contract specifications” of futures define the product that is traded. The basic components of a futures contract are:
- Underlying Asset
- Date and Time of Expiry
- Mode of Settlement (Cash or Physical)
- Contract Size
- Type of Futures Contract (Vanilla or Inverse)
- Tick Size
There are two ways of settling a futures contract — cash-settled or physical delivery.
Cash-settled futures require a spot price index to determine the settlement price. In this way, no underlying asset changes hands. Instead, the profit and loss is calculated from the trade price to the settlement price, and parties are credited/debited on their trading accounts accordingly. Examples of exchanges that are cash-settled are BitMEX, OKEx and CME.
Physical delivery futures requires the buyer to buy the underlying asset from the seller at expiry. This implies that the seller must own the underlying asset at expiry for the purposes of delivery. Examples of exchanges that mandate physical delivery are Bakkt and CoinFlex.
Contract size differs from contract to contract. The contract size for CME Bitcoin futures is 5 BTC, while the size for Bakkt Bitcoin Futures is 1 BTC. Do read the contract specifications before trading!
There are two types of futures contracts in the space — vanilla and inverse. A vanilla futures contract has its contract size in the base asset, for example**, 0.1 BTC in a BTC/USD** underlying. An inverse futures contract has its contract size in the quote asset, for example**, 1 USD in a BTC/USD** underlying. The inverse futures contract is most apparent on exchanges that calculate profit and loss in BTC terms – BitMEX, OKEx, Deribit, etc.
Tick size refers to the small price increment of the contract. For example, BitMEX has a $0.50 tick size for their futures, while CME has a $5 tick.
Why Do Traders Trade Cryptocurrency Futures?
Most cryptocurrency futures exchanges allow traders to utilize leverage in the trading of futures. This means that the trader does not need to have collateral equal to the size of their position — they can use a smaller account to control a larger position. This creates flexibility for the trader to size their positions and extends the use of available capital. However, leverage is a double-edged sword. Having too much leverage creates the risk of liquidation on the position or the account if prices move adversely against the position. Bitcoin is a volatile product, so watch your leverage!
When trading on spot markets, every bid and ask represents actual assets that must be available. A seller needs to own the underlying asset before placing an offer, and the buyer needs to own the underlying capital (USD, USDT, etc.) before placing a bid. When trading derivatives like futures, contracts are created and backed by margin requirements. Hence, traders can place larger orders (see leverage), creating liquidity in the derivatives market that is not seen in spot markets.
Given the ability to use great leverage and access to high amounts of liquidity, traders that require a hedge for their position of BTC prefer using futures instead of spot. Think of the miner that can project his estimated output in BTC or the payment processor that knows he will be receiving BTC in the future. Both these parties want to hedge price risk of the asset before they receive the asset. As you cannot sell something on the spot market that you do not yet own, these traders will turn to the futures market to execute their price hedge.
Cryptocurrency futures exchanges allow users high amounts of leverage — up to 100x. This allows users with smaller accounts to control larger positions, allowing for greater rewards when the trade is right. However, leverage is a double-edged sword. An overly leveraged account is never a good idea. Understand the risks before you execute trades on leverage!