There are a multitude of cryptocurrency investing methods. However, crypto futures trading is a popular and easy way since it’s a type of derivative trading that allows investors to speculate on the future price of a cryptocurrency.
It utilises a futures contract, an agreement between two parties to buy or sell a crypto asset, such as Bitcoin, Ethereum or Litecoin, at a predetermined price on a specific date.
It is similar to traditional futures trading but with some key differences. For example, crypto futures trading contracts are typically settled in cash rather than the underlying cryptocurrency. This means the contract buyer will receive or pay the difference between the contract price and the cryptocurrency’s spot price on the settlement date.
Another key difference is that crypto futures contracts are traded on exchanges rather than over-the-counter (OTC). It makes them more accessible to investors.
The article will detail how crypto futures work and all other necessary information.
What Are Crypto Derivatives?
Before diving directly into crypto futures, let’s go through the concept of derivatives that drive future trading contacts.
Derivatives are financial instruments that derive their value from underlying assets, such as stocks, bonds, commodities, currencies, or cryptocurrencies. They allow you to defer risks, speculate on price movements, or gain exposure to otherwise inaccessible markets.
Similarly, crypto derivatives are based on cryptocurrencies or crypto-related events.
These derivatives also allow you to profit from the volatility and diversity of the crypto market. Moreover, traditional derivatives offer a hedge against price fluctuations, regulatory changes, or cyber-attacks. Futures and options are two of the most common derivatives contracts in the financial market.
Futures are contracts that obligate the buyer and seller to exchange a crypto asset at a predetermined price and date in the future. On the other hand, options are contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a specified price and date in the future.
One of the most significant advantages offered by derivative products is standardised lot size. You can find more liquidity and, most importantly, leverage in the market.
What Are Crypto Futures?
As mentioned, crypto futures are a type of derivative contract that engages buyers and sellers to exchange/trade cryptocurrencies at a determined future price.
These are extremely popular since crypto futures are perpetual, unlike traditional futures, which have a fixed expiration date and settlement price. This means they have no expiration date and are settled periodically based on the market price.
One of the main benefits of trading crypto futures is that they allow you to use leverage, which means you can borrow funds from the exchange or broker to increase your exposure to the market.
For example, if you want to buy one Bitcoin futures contract worth $50,000 with 10x leverage, you only need to deposit $5,000 as a margin. It means you can amplify your profits (or losses) by 10 times.
However, trading crypto futures also involves risks like liquidation and funding fees.
Liquidation occurs when the market price moves against the trader’s position and reaches a certain threshold, where the exchange or broker automatically closes their position to prevent further losses.
Funding fees are periodic payments that traders make or receive based on the difference between the spot price and the futures price of the cryptocurrency. These fees ensure that the futures price converges with the spot price over time.
Although crypto futures is also a crypto trading technique, it differs from other methods, such as spot, margin, and options trading. Let’s understand it with a table:
How Big Is The Crypto Futures Market?
According to a report, the global cryptocurrency market size was US $4.67 billion in 2022 and is expected to rocket at a CAGR of 12.5% from 2023 to 2030.
Similarly, the crypto futures market has experienced exponential growth in recent years, driven by the increasing demand for digital assets, the development of innovative trading platforms, and the regulatory approval of crypto derivatives in some jurisdictions.
Many people are eager to invest in the crypto market’s future but are not keen on owning actual cryptocurrencies immediately.
Now, speaking of one of the most common crypto features in the market, the Bitcoin Futures have attracted substantial buyers due to their open interest and trading volumes, especially during periods of high volatility and market sentiment.
As per Coinglass, it has an open interest rate of more than $12 billion across different exchanges. Additionally, the trading volume of Bitcoin Futures touched the global market’s height of $1.3 trillion. However, the current trading volume is lower than the high numbers reached during the 2021 bull run. In May 2021, during that run, the trading volume of BTC Futures reached a staggering $2.69 trillion.
How Does Crypto Futures Trading Work?
Coming to the working mechanism of crypto future trading, it works in the same fashion as traditional futures trading. An exchange issues a future contract into the cryptocurrency market, where the seller and the buyer are at the same price base.
Buyers and sellers agree on a perpetual contract specifying the crypto’s quantity and price. The buyer agrees to purchase the asset at the contract price, while the seller agrees to deliver the crypto at the same price. As crypto futures are a ‘zero-sum game,’ there must be a seller for every buyer in the market.
However, unlike traditional futures trading, these are not bound to be completed within a specific time limit. Then how are they settled? These trading contracts are settled through a mechanism called the funding rate.
What Are Crypto Funding Rates?
The funding rate is a fee paid by one side of the contract to the other, depending on the difference between the contract price and the asset’s spot price. If the contract price exceeds the spot price, long positions (buyers) pay short positions (sellers), and vice versa.
The funding rate helps to keep the contract price close to the spot price. Funding rates are calculated using the following formula:
Funding rate = (Perpetual contract price – Spot price) / Perpetual contract price * 100
For example, if the perpetual contract price is $10,000 and the spot price is $9,900, the funding rate would be 1%. This means that long positions would pay funding fees of 1% to short positions every 24 hours.
These rates are essential in perpetual crypto futures contracts for several reasons.
- They help ensure the price of the perpetual contract aligns with the underlying asset’s spot price. This is important for traders and investors, as it allows them to hedge their positions and gain exposure to the underlying asset without buying or selling it directly.
- Funding rates help prevent market manipulation. By incentivising traders to keep the perpetual contract price in line with the spot price, funding rates make it more difficult for manipulators to move the cost of the contract artificially.
- Funding rates provide a source of income for market makers. Market makers are responsible for providing liquidity to the market by placing both buy and sell orders. In return for this service, they earn a fee. Funding rates are one of the ways that market makers earn income.
Specifications Of A Crypto Futures Contract
Any futures contract must clearly outline the specific details of the agreement, including the following essential terms:
Underlying Asset And Contract Size
The underlying asset in a futures contract is the asset on which the contract is based. It can be a physical commodity, such as crude oil or wheat, or a financial instrument, such as a stock index or a cryptocurrency, such as Bitcoin or Ethereum.
Moreover, the contract size is the quantity of the underlying asset that each contract represents.
For example, one Bitcoin futures contract might have a contract size of 1 BTC, meaning that each contract is equivalent to 1 BTC in value. Alternatively, the contract size can be denominated in a currency, such as US dollars ($). For example, one Bitcoin futures contract might have a contract size of $1, meaning each contract equals $1 worth of BTC.
The contract size determines the leverage and margin requirements of the futures contract and the traders’ profit and loss potential of the traders. Different crypto futures platforms may offer different contract sizes for other crypto assets, so you should always check the specifications of the contracts before trading.
Futures contracts can be settled in two main ways: physical delivery and cash settlement.
Physical delivery means that the seller of the contract delivers the underlying asset to the buyer at an agreed location and time. The buyer pays the seller the agreed price for the asset. Physical delivery is common for commodities such as wheat, oil, gold, etc.
On the contrary, in a cash settlement, the buyer does not receive the asset but only the cash equivalent. This means that the seller of the contract pays the buyer of the contract the difference between the contract price and the market price of the underlying asset at the expiry of the contract.
Cash settlement is typical for financial instruments such as stock indices, interest rates, cryptocurrencies, etc.
The settlement procedure of a futures contract depends on the contract’s specifications, which are determined by the exchange where the contract is traded. The specifications include details such as:
- The underlying asset and its quality, quantity, and unit of measurement
- The contract size and the minimum price movement (tick size)
- The contract months and the last trading day
- The delivery month and the delivery date
- The delivery location and method
- The settlement price and method
Price And Position Limits
In futures trading, price and position limits are essential features to note.
Price limits are the minimum and maximum prices permitted by the exchanges for a futures contract in each trading session. The maximum price is termed limit up, while the minimum permitted price is termed limit down. These price limits are measured in ticks and vary from product to product. Varied actions occur when markets hit the price limit depending on the traded product.
Now, if the market hits the upper or lower limits decided by the exchange, some may temporarily halt until price limits can be expanded. In contrast, others may stop trading altogether for the day based on regulatory rules.
Price limits are designed to prevent excessive volatility and market manipulation by restricting the price movements of futures contracts within a specific range. It can also help traders manage risk exposure by indicating the maximum possible loss or gain in a given day.
On the other hand, position limits are the maximum number of futures contracts a trader or a group of affiliated traders can hold or control in a particular market.
Position limits are determined on a net equivalent basis by contract, which means that a trader who owns one options contract that controls 100 futures contracts is viewed the same as a trader who owns 100 individual futures contracts.
These limits are established to prevent any entity from exerting undue influence or control over a market and manipulating prices for personal benefit at the expense of others. The aim is to preserve market integrity and liquidity by ensuring enough supply and demand in the market to facilitate trading.
The notional value of a futures contract demonstrates the value of the assets underlying the futures contract. To calculate the notional value of a futures contract, the contract size (in units) is multiplied by its current price.
Contract Notional Value = Contract Price x Contract Size
For example, if you have a futures contract for gold with a contract size of 100 troy ounces and a current price of $1,800 per ounce, the contract’s notional value is 100 x $1,800 = $180,000. The contract represents $180,000 of gold at the current market price.
Notional value is used to gauge hedge ratios, the number of contracts needed to hedge market risk. The hedge ratio calculation is as follows:
Hedge ratio = Value at risk / Notional value
Here, value at risk is the amount of an investor’s portfolio at risk—or subject to loss related to a particular market.
For example, imagine you have a $1 million position in gold that you want to hedge against future losses. You would use a futures contract to do so.
Continuing with the abovementioned gold futures example, it would take roughly 5.6 of the gold futures contracts to hedge your position ($1 million divided by $180,000). By calculating notional value, you can see what actions you need to take to understand and plan for the risks of trading futures.
Minimum Price Fluctuation
The minimum price fluctuation, also known as a tick, is the smallest increment or decrement that the price of a futures contract can change.
For example, a Bitcoin futures contract with a tick size of $5 means that the price can only move up or down by multiples of $5, such as $50,000, $50,005, $50,010, etc.
The tick size determines the precision and granularity of the price movements in the futures market. It also affects the profit and loss of the futures contract traders.
A larger tick size means the price can change significantly in each step, resulting in higher potential gains or losses. A smaller tick size means the price can change gradually and smoothly, resulting in lower potential gains or losses.
Profit And Loss (P&L)
Profit and Loss (P&L) is the difference between the value of a crypto futures contract between opening and closing a position. To calculate the P&L for a crypto futures contract, you need to know the contract size, the tick size, and the current trading price of the contract.
For example, one Bitcoin futures contract on Kraken Pro has a contract size of 1 BTC, a tick size of $0.01 and a current trading price of $50,000.
To calculate the P&L for a crypto futures contract, you need to multiply the change in price (in ticks) by the contract size and the tick value.
Profit or Loss per Contract = Number of Ticks Moved × Value of a Tick.
The tick value is the amount of money that one tick represents. For example, one Bitcoin futures contract on Kraken Pro has a tick value of $0.01.
Suppose you buy one Bitcoin futures contract on Kraken Pro at $50,000 and sell it later at $51,000. So, the price change is 100 ticks ($51,000 – $50,000 = $1,000 / $0.01 = 100).
The P&L is 100 x 1 x $0.01 = $100.
Alternatively, you sell one Bitcoin futures contract on Kraken Pro at $50,000 and buy it back later at $49,000.
The price change is -100 ticks ($49,000 – $50,000 = -$1,000 / $0.01 = -100).
The P&L is: -100 x 1 x $0.01 = -$100.
The Lifespan Of A Crypto Futures Contract
A futures contract has a finite lifespan, meaning it expires at a certain point. Depending on the type of contract, there are three possible choices regarding futures expiration: offsetting, rolling over, and settling.
Offsetting The Position
Offsetting a position before expiration means closing the contract by taking the opposite position in the same contract.
For example, if you have a long position in a Bitcoin futures contract, you can offset it by selling the same contract before it expires. This way, you can lock in your profits or losses without waiting for expiration.
Rolling Over Any Futures Contract Of A Crypto
Rolling over a position before expiration means closing the current contract and opening a new one with a later expiration date. For example, if you have a long position in a Bitcoin futures contract that expires in December, you can roll it over by selling the December contract and buying a March contract.
This way, you can maintain exposure to the underlying asset without settling the contract.
Settling A Contract Of Crypto Futures
Settling a position at expiration means fulfilling the terms of the contract by delivering or receiving the underlying asset or its cash equivalent.
For example, if you have a long position in a Bitcoin futures contract that expires in December, you can settle it by receiving Bitcoin or its cash value at the predetermined price. This way, you can acquire or dispose of the underlying asset at the agreed price.
However, most crypto futures contracts do not lead to delivery because most traders prefer to offset or roll over their positions before expiration. Delivery is usually costly and cumbersome, transferring the actual cryptocurrency or its cash equivalent between the parties.
Moreover, delivery exposes you to counterparty risk, the risk that one party fails to fulfil your obligations under the contract. Therefore, most crypto futures contracts are settled in cash, which means you pay or receive the difference between the contract price and the market price at expiration.
How Crypto Futures Work On Regulated Exchanges?
Crypto futures, when traded on regulated exchanges, such as CME Group, offer standardised contracts with clear rules and regulations.
Suppose a trader wants to trade a CME Group Bitcoin futures contract with a contract size of 5 bitcoins and a margin requirement of 35%.
At the time of writing, the price of one Bitcoin is $50,000, so the contract value is $250,000. To open a long position (betting that the price will go up), the trader must deposit at least 35% of $250,000, which is $87,500. This is called the initial margin.
If the bitcoin price rises to $55,000, the contract value increases to $275,000, and the trader’s profit is $25,000. This is a 28.6% return on the initial margin. However, if the bitcoin price falls to $45,000, the contract value decreases to $225,000, and the trader loses $25,000. This is a 28.6% loss on the initial margin.
To avoid defaulting on your obligations, you must maintain a minimum level of funds in your account, called the maintenance margin.
If the account balance falls below this level due to market fluctuations, you will receive a margin call from the exchange, requiring you to deposit more funds or close your position. If you fail to meet the margin call, the exchange will liquidate its position at a loss.
How Crypto Futures Work On Unregulated Exchanges?
The working mechanism for unregulated exchanges differs from that of the regulated one.
Unregulated exchanges do not have a license from any significant international body or authority, such as the CME or the CBOE. They often offer higher leverage, meaning you can control more prominent positions with less capital.
For example, Binance, one of the largest unregulated crypto exchanges, used to offer up to 125x leverage on some futures contracts but recently reduced it to 20x amid regulatory pressure.
Higher leverage also means higher risk. As a trader, you can lose more than your initial margin if the market moves against you. Unregulated exchanges may also have less liquidity, security, and transparency than regulated ones, which can lead to price manipulation, hacking, or fraud.
Additionally, unregulated exchanges may not comply with anti-money laundering (AML) and know-your-customer (KYC) rules, exposing you to legal issues or sanctions.
Where Can You Trade Cryptocurrency Futures?
A list of prominent cryptocurrency futures trading platforms is as follows:
It is the largest cryptocurrency exchange in the world, as measured by trading volume. It played a substantial role in the Bitcoin perpetual and futures market, contributing $26 billion to the overall trading volume. It offers futures contracts for various cryptocurrencies, such as Bitcoin, Ethereum, Binance Coin, Cardano, and more.
Phemex is a relatively new platform launched in 2019, but it has quickly gained popularity among crypto traders. It had a trading volume of $5.1 billion by October 2023. It offers perpetual and fixed-date contracts for Bitcoin, Ethereum, Chainlink, and more.
OKX is one of the world’s oldest and most established cryptocurrency exchanges. It had a trading volume of $10.4 billion in October 2023. It offers various futures products, including perpetual and fixed-date contracts for Bitcoin, Ethereum, and Tether.
While it may not be as well-known as Binance to U.S. audiences, ByBit ranks among the world’s biggest cryptocurrency exchanges. It had a trading volume of $7.5 billion in October 2023. It specialises in perpetual contracts for Bitcoin, Ethereum, XRP, and EOS, with leverage up to 100x.
Bitget is another newcomer founded in 2018 and has grown rapidly since then. It had a trading volume of $4.4 billion in October 2023. It offers perpetual contracts for Bitcoin, Ethereum, Litecoin, and more.
Advantages And Disadvantages Of Crypto Futures Trading
Crypto futures trading is a form of derivative trading that allows investors to speculate on the price movements of cryptocurrencies without owning the underlying assets.
Crypto futures have several advantages, such as:
- Leverage: Crypto futures enable you to use leverage, which means you can control a more prominent position with less capital. This can amplify their profits, but also your losses.
- Flexibility: Crypto futures offer flexibility regarding contract size, expiration date, and trading platform. You can choose from various contract specifications and trade on different exchanges or platforms that suit your needs and preferences.
- Simplicity: One of the significant advantages of engaging in cryptocurrency futures trading is the ease of speculating on the underlying assets’ price fluctuations.
- Perpetuity: Crypto futures are often perpetual, which means they do not have an expiration date and can be held indefinitely. This eliminates the need to roll over contracts, pay additional fees, or deal with settlement issues.
- Hedging: Crypto futures can also be used as hedging tools to protect against adverse price movements of cryptocurrencies. You can take opposite positions in the futures market to offset your exposure in the spot market.
However, crypto futures trading also has some disadvantages, such as:
- Misuse of leverage: Leverage can be a double-edged sword that can magnify losses and gains. If, as a trader, you use excessive leverage or do not manage risk, you can face margin calls or liquidation.
- Ownership issue: Crypto futures do not grant ownership of the underlying cryptocurrencies. If you want to hold or use the actual coins, you may prefer to buy them in the spot market instead of trading futures contracts.
Managing Risk In Crypto Futures Trading
As a crypto futures trader, you can profit from rising and falling markets but risk losing your entire capital or even more if you trade on margin. Therefore, managing risk in crypto futures trading is crucial for long-term success.
Risk management involves applying a set of rules and techniques that aim to limit the exposure to potential losses and preserve the trading capital.
Some of the critical aspects of risk management are:
Learn Money Management
This refers to how much money you will risk on each trade based on your account size, risk tolerance, and trading objectives. A common rule of thumb is to risk no more than 1% to 2% of the account balance per trade. This way, you can withstand losing trades without blowing up your account.
Use Take-Profit And Stop-Loss Orders
These orders automatically close a trade when a certain price level is reached, either locking in profits or cutting losses. Take-profit orders help you to secure gains and avoid missing out on favourable market movements. Stop-loss orders help you limit their losses and prevent them from holding on to losing positions for too long.
Controlling Your Emotions
Trading is a psychological activity involving fear, greed, hope, and regret. Emotions can cloud a trader’s judgement and lead them to make irrational decisions that deviate from their trading plan.
For example, you may close a winning trade too early out of fear of losing profits or hold on to a losing trade too long out of hope for a reversal. To avoid emotional trading, you must have a well-defined trading strategy that specifies the entry and exit criteria and the risk-reward ratio for each trade.
Have A Trading Plan
A trading plan is a document that outlines the trader’s goals, strategy, risk management rules, and performance evaluation methods. It helps you stay focused and disciplined, track your progress and identify areas for improvement. However, these plans should be realistic, flexible, and consistent with your personality and style.
Do Not Overtrade
Overtrading is a common mistake when you take too many trades or trade with too large positions out of boredom, excitement, or frustration. It can result in excessive fees, commissions, slippage, margin calls, and increased stress and fatigue.
The ratio measures how much you can lose versus how much you gain on each trade. It is calculated by dividing the potential loss by the potential profit. For example, if you risk $100 to make $200 on a trade, the risk-to-reward ratio is 1:2. It helps you assess the quality of their trades and determine whether they are worth taking.
Why Trade Crypto Futures?
Crypto futures have three primary purposes: hedging, speculation, and arbitrage.
Hedging reduces or eliminates the risk of holding a particular asset by taking an opposite position in the futures market. For example, if you own some bitcoin and expect the price to drop shortly, you can sell futures contracts to lock in the current price and protect your profits.
Speculation is the practice of betting on the future price movements of an asset with the hope of making a profit. For example, if you expect the price of Ethereum to rise shortly, you can buy Ethereum futures contracts to benefit from the potential increase.
Arbitrage exploits price differences between different markets or platforms for the same asset. For example, suppose you notice that the price of litecoin is lower on one exchange than another. In that case, you can buy litecoin on the cheaper exchange and sell it on the more expensive one, or vice versa, using futures contracts to lock in the profit.
Tax Implications On Future Contracts In India
Cryptocurrencies in India fall into virtual digital assets and are subject to taxation. The key points regarding crypto taxation include a tax rate of 30% (and a 4% cess) on gains from crypto trading under Section 115BBH.
In addition to this, Section 194S requires a 1% TDS on any crypto asset trades over ₹50,000 in a financial year. This tax applies to all individuals and businesses, irrespective of their private or commercial classification, who engage in digital asset transfers at any point during the year.
To tackle such complex taxation, you can choose KoinX. It is a crypto tax computing software that helps give reliable tax reports.
Crypto futures trading can be a rewarding and exciting way to participate in the cryptocurrency market, but it also involves significant risks and challenges. You should understand how futures contracts work, use leverage wisely, and identify and exploit arbitrage opportunities to make informed decisions.
However, crypto future trading can have tax implications. Manual calculation of taxes for each trade can get time-consuming. Therefore, you can try KoinX, an automated crypto-tax reporting software designed to offer accurate crypto-tax reports. Join KoinX today to make your crypto future trading taxation easier.