What is futures trading?
Trading futures means agreeing to buy or sell an asset at a pre-set price by a specific date. Since futures contracts only have value in relation to another product, they’re known as derivatives. Unlike the spot market, derivatives markets don't give traders access to the commodity, stock, or crypto they track. All you're buying in the futures market is a contract that follows the asset's price.
Traders can bet that the price of an investment will go up or down by buying or shorting a futures contract. Besides perpetual futures, every futures contract has a clear price and date when traders need to meet their obligation. A futures trader profits if the asset in question moves in the direction they predicted by the expiration date.
Initially, exchanges created futures to provide investors with certainty over commodity prices. For instance, a bread company could lock in the current price of grain by purchasing wheat futures at the current rate. The bread manufacturers can better predict their operating expenses with these contracts. Today, many investors use futures to speculate prices or protect their long-term holdings (aka hedging).
Types of assets used for futures trading
Traditionally, futures contracts were closely associated with commodities like grains, crude oil, and lumber. While commodities futures are still actively traded, dozens of other asset classes are available in the derivatives market.
For instance, it's common to trade precious metals like gold or palladium using futures. Stock traders can invest in futures ETFs (exchange-traded funds) or contracts for specific companies. Futures are also available in the forex and cryptocurrency markets.
How does futures trading work?
Trading futures is similar to buying and selling assets on the spot market. First, open a brokerage account that offers futures. Next, fund your account with cash. Open a long or short position on any futures contract with the money in your account. If long, you're buying a contract that you expect will rise by the expiry date. However, if short, you're betting the price will go down. Instead of buying a contract, short traders sell their position to start and must buy their futures before expiration.
While the mechanics of trading futures is similar to buying on the spot market, remember that you're not holding the underlying asset. Futures are synthetic trading vehicles that only give you access to price exposure. Even if you're trading Bitcoin futures, you’ll settle your positions in cash.
Another defining feature of futures is that they have an expiration date. Whether going long or short on a futures contract, you'll need to close your position at a pre-established time. Most futures contracts also have funding fees you must pay the broker while holding your positions.
Lastly, although it's not a requirement, leverage trading is standard in the futures market. Leverage refers to borrowed funds you can use to artificially increase the size of your collateral. For example, if you had $1,000 in your account and used 10x leverage, your brokerage would lend you 10 x $1,000 = $10,000.
Although leverage is common in crypto futures trading, it’s incredibly risky due to crypto’s volatility. In the example above, your portfolio will rise or fall 10x more than the spot price. So, if Bitcoin rose $500, you’d have a $5,000 gain. Conversely, if BTC fell $500, you’d incur a loss of $5,000.
Not only is leverage trading more volatile, but it also puts traders at risk of forced liquidation. Since the price of your position moves faster than the market price, there’s a level where your collateral won't cover your losses. Leverage futures traders must take these risks seriously before opening a position.
An example of futures trading
As an example, a jeweler may be interested in purchasing gold and silver futures to better manage their business expenses. The COMEX Gold Futures Contract is a standard derivative product used in precious metals. Anyone who holds one of these contracts can claim 100 Troy ounces of gold at the agreed-upon rate by expiration.
If a jeweler expects gold prices to rise by year-end, they may want to purchase a futures contract now to avoid paying a premium later. The jeweler could buy a COMEX Futures Contract at $1,800 per gold ounce at the start of the year with a December expiration. If the price of gold trades at $2,000 before expiration, the jeweler would have saved $200 per ounce. However, if the price of gold fails to go above $1,800, the jeweler would have to pay extra for their gold inventory when exercising this contract.
Although futures contracts like COMEX have future delivery obligations, not everyone chooses to exercise this option. Instead, many businesses and industries will sell their contracts on the open market if prices are favorable. Either way, futures contracts help provide a measure of certainty and protection when dealing with commodity prices.
What is futures trading in crypto?
Futures trading in crypto is the same as trading futures for stocks, precious metals, or commodities.
Currently, the CME only accepts Bitcoin and Ethereum for futures trading. However, it’s possible to open futures positions on many other altcoins (or non-Bitcoin cryptos) on centralized cryptocurrency exchanges (CEXs).
Most crypto futures are cash-derived, which means you’ll open and close your positions in fiat currencies like the USD. In contrast, physically derived futures require you to finalize your payment in crypto. For instance, if you bought physically derived Bitcoin futures, you’ll receive BTC whenever you sell your contract.
Since most traders use futures to avoid handling crypto assets, it's not as common to find physically derived futures. However, some platforms like Bakkt offer this service.
Most crypto futures expire, but there are perpetual crypto futures. As the name implies, perpetual crypto futures have no expiration. If you're in a perpetual futures contract, you’ll constantly pay or collect fees depending on which way the price goes.
Perpetual futures contracts are similar to investing in crypto on the spot market. However, these contracts make it easier for investors to add leverage to their position or short a crypto asset. Some people may open a perpetual future to hedge a long position when the price of their holdings goes down. Others use perpetual futures to receive price exposure to Bitcoin, Ethereum, or another altcoin without dealing with crypto storage.
Why do investors use futures trading in crypto?
Crypto derivatives like futures offer many unique features that may be more attractive for various investment scenarios.
- Helps hedge long crypto positions: Many long-term crypto investors use derivatives to manage losses in their favorite cryptocurrencies. Since futures contracts only track the price of a crypto, you don't have to sell or short your tokens. Instead, you could profit from downward prices by selling short futures while holding your BTC or ETH.
- Simpler to understand for traditional investors: Derivatives traders may feel more comfortable speculating on Bitcoin's price by investing in futures rather than holding BTC in a wallet. Not only is there a higher learning curve involved in transferring crypto tokens, but there’s also always the risk of a cyberattack or a misplaced seed phrase.
- Better regulated than crypto exchanges: Futures exchanges like the CME fall under the purview of the U.S. government. Traditional asset managers may feel more comfortable using regulated institutions like CME Group than relying on a private crypto exchange.
- Easier to short futures: Traders don't need to hold any crypto to take advantage of short futures contracts. If they feel a digital asset’s price will drop, they can open a short futures position with whatever collateral they have in their trading account.
- Access to leverage: Futures traders can increase their position size by borrowing funds from their broker. While leverage trading is risky, it's a common reason many traders use futures.
What are the risks of crypto futures trading?
Crypto futures contracts have potential advantages but not without a few significant risks.
- Subject to funding and insurance fees: Traders buying crypto futures contracts have to pay funding fees for as long as they hold this derivative. Some CEXs also have insurance fees that may cut into any profits traders collect.
- CEXs have less federal oversight: CEXs like Binance don’t offer the same security and protection as organizations like the CFTC.
- May give crypto traders less flexibility: In the case of highly regulated derivatives markets like the CME, traders have to abide by strict requirements when buying futures contracts. For instance, CME Bitcoin futures trading has a contract unit of 5 BTC. Also, although cryptocurrencies trade 24/7, the CME is only open during business hours between Sunday and Friday.
Here’s how a beginner can start crypto futures trading
Many brokerage sites like Interactive Brokers offer access to futures products like CME Group's Bitcoin and Ethereum contracts. If you want access to more crypto futures than those on the CME, set up an account on a CEX that offers futures.
A few prominent CEXs that offer crypto futures trading include:
- Binance
- Bybit
- FTX
- KuCoin
- Kraken
You can also purchase Bitcoin futures ETFs with a stock market account. Various funds like Valkyrie, ProShares, and VanEck now offer Bitcoin ETFs that hold futures contracts on your behalf.
Wrapping up
Crypto futures trading is a new way for investors to add Bitcoin or Ethereum to their portfolios. While these derivatives are often settled in cash, they highlight the growing mainstream adoption of digital asset trading.
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