There are many ways to get exposure to cryptocurrencies, but futures trading is one of the most popular and convenient approaches. It can provide better opportunities compared to spot trading and options trading. Here’s exactly what you need to know about futures trading crypto and how do futures contracts work.
What is Futures Trading Crypto?
Futures trading refers to a mETHod of speculating on the price of assets, including cryptocurrencies, without actually owning them. Like commodity or stock futures, cryptocurrency futures enable traders to bet on a digital currency’s future price. Needless to say, Bitcoin futures are currently the most popular type of crypto futures contracts.
What Is a Futures Contract?
Futures contracts are part of a large category of trading instruments known as derivatives. Initially, futures contracts made sense for many commodities, including foods, oil, and metals. However, they soon went beyond their practical reasons to conquer all financial markets, including cryptocurrencies. Today, most commodity price quotes you see on financial portals involve futures, usually with a monthly expiry date.
In a nutshell, a futures contract is an agreement between two parties to either buy or sell an asset, such as digital currency, on a predetermined date, at a predetermined price. The contract tracks an underlying asset, be it a commodity, stock, or cryptocurrency. It is basically a form of bet on the future price movement.
For example, if you think that Bitcoin (BTC) will increase in price by the end of the month, you would be interested in opening a long position on the cryptocurrency by buying a Bitcoin futures contract with a monthly expiry date. Otherwise, if you believe Bitcoin’s price will go bullish, you would go long. At the contract’s expiry date, the two parties involved in the trade settle, and the contract closes.
How Do Futures Contracts Work?
Futures contracts are among the most popular types of derivatives. It grants buyers the right to purchase an asset and sellers to sell an asset at a fixed price in the future (agreed upon date). Most traders close their futures contract before the contract expires, booking their profit or loss in the process. Typically, traders would use a futures contract to hedge other investments when trading in a volatile market like crypto.
Take Bitcoin as an example. If a trader believes the price of 1 BTC could fall after crossing $18,000 (at the end of November 2020), the trader will use a futures contract as a hedge to protect his current margins. Assuming the trader purchases a futures contract with one-month maturity, if the prices go below $18,000, the trader would be able to safeguard his profit.
However, in the reverse scenario, the trader will lose on any gains Bitcoin books over the next month.
How Does Futures Trading Work?
If you had watched the process of cryptocurrency futures trading on a crypto exchange platform, you wouldn’t tell the difference from regular trading. That’s mainly because traders do precisely the same thing in both cases – open long and short positions and implement proper risk management techniques.
However, futures contracts are very different from spot trading because they don’t operate with the underlying assets but only with their price action. Without the actual asset, futures are way more fluid and easier to handle. Also, they enable margin trading with high leverage.
Types of Cryptocurrency Futures Contracts
There are several types of futures contracts that crypto traders can choose from. It’s worth mentioning that most platforms do not provide all of the listed types, so make sure to select the suitable futures exchange.
Standard Futures Contracts
Regular cryptocurrency futures have all the aspects of a standard futures contract from traditional markets, including expiry and settlement. Chicago-based CME Group and CBOE were the first futures trading exchanges to launch Bitcoin futures contracts back in December 2017. In fact, this was one of many reasons that boosted the BTC price to a record high at the time.
Today, CME provides several Bitcoin futures with different expiry dates, as seen in its Bitcoin Futures Calendar. All contracts are settled in U.S. dollars at the expiry. Elsewhere, CBOE decided to abandon its Bitcoin futures contracts, but it would definitely bring them back soon as the interest in crypto is surging.
On the contrary, some crypto exchanges do provide standard futures contracts. Like Bybit, FTX, Deribit, and Binance, most of them offer quarterly Bitcoin futures and the contracts commonly dealt with in U.S. dollars. They are often settled every three months and are ideal for swing trading.
Futures with Physical Delivery
Another type of cryptocurrency futures that also have expiry dates are futures with physical delivery. They were first introduced by Bakkt, an entity backed by Intercontinental Exchange (ICE), the parent New York Stock Exchange (NYSE). The only difference from the regular futures described above is that cryptocurrency is actually delivered during the settlement process.
Bakkt now offers only Bitcoin futures with physical delivery, meaning that it transfers Bitcoin at the expiration date to those who bought futures on the cryptocurrency. As a cash-settled futures contract, this approach aims to contribute to the Bitcoin circulation.
Perpetual Contracts
Perpetual contracts represent another popular type of cryptocurrency futures. Since it does not rely on the expiration date, perpetual contracts quickly took off on BitMEX, and were soon being adopted by major crypto exchanges, including Bybit, FTX and Binance.
The primary mechanism that helps perpetual contracts keep as close to the spot price as possible is funding. Traders are paying each other based on their open positions at certain hours. The difference between the perpetual contract price and the spot price decides who pays and who gets paid. Thus, when the funding rate is positive, traders who have long positions pay shorts, and when the funding rate is negative, shorts pay longs.
A worthy note for traders on Bybit, the funding payments are carried out every eight hours, and the perpetual contracts are traded in USDT and other stablecoins. The crypto perpetual futures market has grown rapidly, but there is still room for improvement in the trading volume compared with conventional futures exchanges.
Despite the large drop in crypto prices in 2022, trading volume for perpetual futures has slumped but they have not been affected as much. According to coinglass data, average futures volume still ranges around $50B - $200B. Crypto futures will continue to be an area with huge potential and will be hugely contested amongst the top exchanges as well as decentralized exchanges.
Closing Thoughts
Both institutional and retail traders prefer cryptocurrency futures after learning about how do futures contracts work thanks to their convenience and lower risk of hacking attacks than the spot market.
Crypto futures are still more popular than crypto options, which represent another type of derivatives. In an option contract, the buyer of the option has the right but not the obligation to buy the underlying asset in the case of a call option or sell it in the case of a put option at a predetermined price within a certain period.
Both derivatives enable traders to hedge against volatility risk and experience new trading forms that can end up more profitable than regular trading.
