- Bitcoin futures contracts are bets on the future price of Bitcoin.
- You can bet long (you believe the price will go up) or short on its price (the price will go down).
- With leverage options, investors can maximise their profits multiple times over. But the higher the leverage, the smaller the margins for error in price prediction.
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In our last chapter on investing in crypto, we explored how staking and lending can help grow your holdings passively. In this chapter however, we’re going to be taking a step onwards and looking at how you can increase your holdings by investing actively.
Below we’ll explore in more detail, how they work, why traders use them, the risks involved, and where to get started.
What are Bitcoin Futures?
First, it’s important to understand what we mean by futures trading. As a first distinction, spot trading is what most people who invest in crypto do right now. They buy or sell a cryptocurrency at the price it is at that moment. This is a spot trade.
A futures trade, or a futures contract, is an agreement between a buyer and a seller - there has to be both in order for a contract to be agreed upon - to speculate on what the price of an asset might be worth in future.
So for example, if you’d taken out a futures contract in March of 2020 saying that you’d buy Bitcoin in November for $5,000, and someone agreed to sell Bitcoin at $5,000 you’d be laughing as the seller has to sell their Bitcoin at that price.
If however you’d said that would be worth $50,000 in January, and someone met that bet, you’d have to buy that Bitcoin at the inflated price.
There are more complexities to futures trading than that, and if you’d like to know more about it, you can read more about it in our learn guide, here.
But what’s important to point out at this point is that Bitcoin futures have become an extremely popular trading instrument, as we’ll discuss below.
Why do traders use futures contracts to trade?
The first key reason futures contracts are used by traders is because they allow an investor to amplify their profits through something called leverage.
Leverage allows an investor to put down an amount of money and gain access to a greater amount. For example, if you put in $1000, you can effectively enter the market with $100,000 in markets that offer 100x leverage. Let’s look at another example.
If you enter the market with $1,000 USD and close your position once the price has risen by 2%, you will have made $20 profit. If, however, you trade with a 100x leverage, that 2% would have yielded $2,000 USD, doubling your initial investment. Trading on futures markets can amplify profits more than almost any other form of short-term trading.
But with that comes the opportunity to lose money very quickly. Liquidation in futures trading is what happens when you incorrectly guess the movement of the market and the exchange you’ve taken the contract with terminates the order and you lose all your initial investment. There also other benefits, too.
Did you know?
In 2020, aggregate open interest for Bitcoin futures grew by 175%.
Plus, many home offices and investors use accounting software that might not be able to process the data flows from wallets or exchanges from spot exchanges. Futures trading on the other hand, is something most investors are familiar with.
“Futures contracts have opened the doors to more traditional investors who may not be ready to allocate funds to the asset itself, but who still want to benefit from its attractive price action,” says a spokesperson from AAX, the world’s first digital asset exchange powered by the London Stock Exchange.
What does a trader need to understand about futures trading in crypto?
The first part of buying futures contracts is that you’re not actually buying the underlying asset, in this case, Bitcoin. Instead you’re taking out a contract that predicts the price is going to rise (go long) or the price is going to drop (to short an asset).
The next is understanding your leverage options. Different exchanges will offer different amounts of leverage. At AAX, you can access 100x leverage. That means if you put in $1,000 at 100x leverage, you would effectively be buying 100,000 contracts worth $100,000.
If you go long, for example, and you decide to close your position once the price has risen by 5%, you’ll have made a $5,000 profit. If you exit at 10%, your profit would be $10,000.
Now, if you guess wrong, and the market moves the other way, you will lose the amount you put in (and no more). In the above case, $1,000.
Leverage effectively acts as a confidence indicator. The more certain you are of a movement upwards or downwards, the more leverage you would apply. However, the more leverage you apply the less volatility the contract will tolerate, meaning even a small diversion in price will lead to your contract being liquidated.
If however, you put less leverage into a contract, there will be more room for market shifts.
Lastly, you need an understanding of how an exchange deals with futures contracts. At AAX, for example, the exchange will close the contract before you hit the total amount you put in to ensure traders aren’t then having to cover greater losses than they were expecting.
For example, if you had bet $1,000, AAX would close out your position as close to that number as possible to prevent further losses. If however you did incur losses over $1,000, AAX would cover the difference via something called the Default Fund.
The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment, or other advice.