Futures trading: Everything you need to know

The rise of digital currencies has changed the way we think about money and finance. With cryptocurrencies like Bitcoin and Ethereum becoming popular since 2009, many other forms of digital money have emerged, creating a lively and ever-changing market.

This market is influenced by how much of a currency is available, how many people want to buy or sell it, or HODLING. and the overall mood of investors , making it both exciting and risky for traders.

One interesting financial tool in this space is the futures contract. These contracts let people bet on whether the price of a cryptocurrency will go up or down without actually owning the coin itself. First used in traditional finance over a hundred years ago, futures contracts made their way into the world of cryptocurrencies in 2017.

This article will explain what these contracts are, how they work, and what to think about if you want to trade them.

What are future contracts in cryptocurrency?

From the name, future contracts are agreements made against the future. It is an agreement to buy or sell an asset at a set price on a predetermined date in the future.

The seller must sell the assets, and the buyer must buy the asset at the agreed price and date with no recourse to the market price.

Future contracts keep tabs on an underlying asset, for this discussion, a digital currency.

In Future contracts, traders can decide to short (sell) an asset when they anticipate a dip in price or go long (buy) when they think there is a bullish trend. The concerned parties (buyers and sellers) will settle once the contract expires.

There is no actual buying and selling of the assets; thus, the parties are settled with fiat once the contract expires.

Future contracts utilize the volatility of the cryptocurrency market to their advantage. Surmise it to say that Futures traders bet or place wagers on the volatility of the crypto market.

It is similar to stock and other traditional finance trades where investors are known to take risks on the future value of an asset.

Future contracts trade 24 hours a day, seven days a week on top cryptocurrency exchange platforms, where traders are given access to various tools to manage their portfolios and trade.

How cryptocurrency futures work

The primary concern raised by crypto critics is the high volatility of the crypto market. Future contracts traders see volatility as an opportunity to analyse and speculate on the market.

Futures is all about studying fluctuating prices and making trades based on prediction. The whole concept of futures may be confusing, but it can be explained using real-world scenarios.

Consider an example. Mr Davies wants to buy one of the Loius Vuttion's (LV) Sprint sneakers, sold at $900 at the time. Mr Davies intends to pay and get the Sneakers by next month, December.

There are different reasons Mr Davies may not want to pay for the LV sneakers immediately.

Either Mr Davies cannot afford it (he has only $200) but believes the price of the sneakers will shoot up (let's say to $1,500) in December, so he decides it is best to secure the LV sneakers at the current market price, or he does not need the sneakers at the moment.

To secure a deal, Mr Davies goes to the nearby Louise Vuttion shop and proceeds to sign an agreement (a contract) with the manager. Mr Davies could ask the manager to sell the LV sneakers to him at $1,000 (remember the current price is $900) on 20th December.

The LV shop manager accepts this contract because he forecasts that the sneakers' price will dip in December.

Flash forward to 20th December, two scenarios can play out: The price

1. rises above $1000 and sold at $1500 or
2. crash below $1000, selling at $600.

Concerning the existing contracts, Mr davies must buy the sneakers on 20th December at $1000, and the shop manager must sell at $1000 irrespective of the market price.

If scene 1 plays out, Mr Davies will buy the LV sneakers at $1000 and could sell at the market price of $1,500, then make a profit of $500 (i.e. $1500-$1000). On the other hand, the LV shop loses $500 since it was bought at $1500 but sold at $1000.

In the case of scenario 2, Mr Davies stands to lose $400 while the LV shop will make a profit of $400 because they bought at $600 and sold at $1000.

Future contracts are also applicable in the manufacturing industries. For instance, a winery could enter into a futures contract with a barley farmer to buy barley at a fixed price rate over a long period.

It will enable the winery to continue production at a fixed cost, not minding the fluctuating price of barley.

However, future contracts in crypto do not entail the buying or possessing of the underlying asset. The basis of future contracts in crypto is

• the price of the asset at the time,
• the contract,
• the price at expiration time,
• loss and profit.

Futures trading could be perpetual or time-bound. For perpetual, the trade executes until the account is liquidated or paused by the trader. On the other hand, time-bound future contracts expire after the set period.

Basic terms of futures trading

Potential traders must learn and understand the basic concepts and terms of futures trading. The road to becoming a professional trader starts from the basics.

Some of the popular terms of futures trading are explained below:

1. Leverage

The beauty of futures trading lies in leverage. Leverage makes future contracts less capital-intensive.

For instance, as at press time, the price of BTC is over 60,000 USD, with leverage, traders do not need to put up that much capital to short or go long on the price of BTC.

Exchanges like Binance etc., offer leverages from 1X to even 125X.

The implication is, when traders short an asset and the price dips by 5% (more or less), the trader stands to get the profit multiplied by the leverage selected before the trade is executed and vice versa.

There are three basic principles to observe in leverage:

• Maintain low levels of leverage, 5X or less,
• Making use of stop-orders to protect capital
• Not using more than 2% of the capital on each position.

In summary, more leverage equals more profit and more risk.

2. Initial margin

The initial margin is directly proportional to the leverage. Initial margin is the percentage of the position's value that traders must deposit before opening a position or entering a trade.

If a trader selects 20X leverage, then he must deposit 5% of the opening position.

3. Liquidation

It is similar to the bull entering a Chinese shop. Liquidation is a term that no trader wants to experience.

It is the forcefully closing of a trader's leveraged position by the exchange due to partial or total loss of the initial margin. Liquidation is often executed to prevent the account from entering negative equity.

The rate of liquidation is linked to the amount of leverage used. If a trader uses higher leverage, the exchange will deplete the trader's initial margin with little or no effort.

4. Open interest

Open interest is an analytical tool that aids decision-making before opening a position. Open interest shows the number of open positions held by participating traders.

It goes up if the net amount of capital entering the market is positive and vice versa. Open interest is updated once per day.

5. Volume

Volume is another concept used to gauge the strength of a market. It is calculated by summing the total number of contracts traded over time.

Traders can also use volume to assess volatility in a market. For instance, if the volume is high and the price of an asset is trending upwards, then the volatility is justified.

Strategies for Successful Futures Trading

Engaging in futures trading demands a well-thought-out strategy to effectively navigate the volatile cryptocurrency market. Here are some constructive approaches:  

Risk Management: Avoid excessive leverage, employ stop-loss orders, and limit the capital allocated to each trade.  

Technical and Fundamental Analysis: Analyze price charts, market trends, and economic indicators to inform your trading decisions.  

Hedging: Utilize futures contracts to mitigate potential losses in spot trading positions, thereby reducing overall risk exposure.

4.0 Conclusion

This article is only but a purview into how futures contracts work. It is worth noting that trading is a very profitable venture but can also lead to total depletion of capital if the market goes against the agreement placed.

Technical analysis of the market and fundamentals is an undeniable tool to succeed in futures trading. Potential traders are advised to tread carefully to avoid loss of savings.