Key Takeaways:
- A crypto futures contract is an agreement to buy or sell an asset at a specific time in the future.
- Futures trading mainly serves three purposes: hedging, speculation, and arbitrage.
- Futures are available on major exchanges for various asset classes, including stocks, indices, interest rates, commodities, and cryptocurrencies.
- Every crypto futures contract has a minimum price fluctuation, also commonly known as a tick.
- The profit and loss of one contract is obtained by multiplying the dollar value of a one-tick move by the number of ticks the futures contract has moved since purchasing the contract.
- The multiplying effect from the contract size and tick movement can have a large impact on the profit and loss of a futures contract.
- Every futures contract expires on a certain date, and a futures trader needs to manage contract expiration.
What Are Crypto Futures?
A crypto futures contract is an agreement to buy or sell an asset at a specific time in the future. It is mainly designed for market participants to mitigate the risk of future price changes in an asset.
The original application of futures contracts was seen in the transactions between farmers and merchants. Suppose a farmer knows in June that he will harvest a known amount of corn in the coming September. The farmer and the merchant come to an agreement on a future contract: the merchant pays the farmer an agreed-upon price, and the farmer must deliver a predetermined amount of corn to the merchant in September. By doing this, both the farmer and the merchant can reduce their price risk through implementing the futures-type contract.
In addition to hedging price risk, futures also allow market participants and traders to profit from speculation and arbitrage. Before diving deep into futures’ functions and trading strategies, however, let’s go over the nuts and bolts of a futures contract first.
Specifications of a Crypto Futures Contract
A futures contract must clearly specify the exact nature of the agreement, and it generally covers the following key terms:
Underlying Asset and Contract Size
Futures are available on major exchanges for various asset classes, including stocks, indices, interest rates, commodities, and cryptocurrencies. The contract size specifies the amount of the asset to be delivered. For example, in a crude oil futures contract, the contract size might be barrels of crude oil.
Settlement Procedure
A futures contract can be settled by physical delivery or by transferring cash positions. Physical delivery requires the actual underlying asset to be delivered upon the specified delivery date, while cash settlement involves transferring of the associated cash position. A contract also specifies where and when the buyer and the seller must settle the contract.
Price and Position Limits
Exchanges usually impose limits on futures’ daily price movement: Limit up and limit down are the maximum amounts a contract may increase or decrease in any single trading day. When markets hit the price limits, some may temporarily halt trading for a certain time or stop trading for the day altogether. Position limits are the maximum number of contracts that a market participant may hold.
Notional Value
The notional value of a contract refers to the product of the contract unit and the futures price.
Contract Notional Value = Contract Unit × Contract Price
Consider an S&P 500 futures contract trading at $3,000. The contract unit of this contract is $50 times 1 index point, where $50 is also known as a multiplier. The notional value of the contract, therefore, is: $3,000 × $50 = $150,000. The notional value can help gauge the hedge ratios versus other futures contracts or another risk position in a related underlying market. We further illustrate the use of hedge ratios in trading strategies:
Hedge Ratio = Value at Risk/Contract Notional Value
The hedge ratio is a risk management tool used to calculate the amount of exposure needed to be hedged in a portfolio. It is calculated as the value at risk (VaR) divided by the contract notional value.
Value at risk (VaR) is, with a certain level of confidence, a statistical measure of the maximum potential loss of funds or portfolio over a given time period. For example, a VaR of $100,000 with a confidence level of 95% means there is a 95% probability that the maximum potential loss on the assets or portfolio will not exceed $100,000 over the given time period.
The contract notional value represents the total value of the financial contract used to hedge the exposure.
By dividing the VaR by the contract notional value, the hedge ratio calculates the amount of exposure needed to be hedged in order to limit the potential loss to the VaR level. For example, if the VaR is $100,000 and the contract notional value is $1 million, the hedge ratio would be 0.1, indicating that 10% of the exposure needs to be hedged.
The hedge ratio can be a useful tool for managing risk in a portfolio, as it can help to identify the appropriate level of hedging required to limit potential losses.
Minimum Price Fluctuation
Every crypto futures contract has a minimum price fluctuation, also commonly known as a tick. It refers to the minimum increment of price movement possible in trading a futures contract.
Take, for example, a bitcoin futures contract, where its minimum tick size equals $5. The dollar value of a one-tick move is calculated by multiplying the tick size by the size of the contract. Thus, the dollar value of a one-tick move in bitcoin futures equals $5 x 5 = $25.
A trader should be aware of the tick value of the futures contract they are trading, as well as the usual tick movements of the contract: They could significantly impact the profit and loss — and the corresponding volatility of the trader’s futures position.
Profit and Loss (P&L)
The following illustrates how to calculate the profit or loss for a crypto futures contract with a typical bitcoin futures contract. We need to consider the contract size, tick size, and the current trading price. A typical bitcoin futures contract represents the expected value of 5 bitcoins. Its price is quoted in US dollars per bitcoin. The minimum tick size is $5, and the dollar value of a one-tick move in bitcoin futures equals $5 x 5 = $25.
The profit and loss of one contract is obtained by multiplying the dollar value of a one-tick move by the number of ticks the futures contract has moved since purchasing the contract.
Profit or Loss per Contract = Number of Ticks Moved × Value of a Tick
Suppose a trader buys one bitcoin futures contract at $26,000, and the current price of bitcoin futures has risen to $30,000. The contract has moved by ($30,000 – $26,000) / $5 = 800 ticks. Thus, the profit per contract is: 800 ticks x $25 per tick = $20,000.
P&L Range
The multiplying effect from the contract size and tick movement can have a large impact on the profit and loss of a futures contract. Before entering a futures position, have a solid understanding of the price volatility of the asset.
For example, as shown above, assume the bitcoin futures contract moves by $800 in a typical day. The value of a typical daily move in dollars equals ($800/5) ticks x $25 per tick = $4,000. There is also another contract for altcoin X, which has a much larger contract size than bitcoin futures. Although its tick size and the average daily movement are much smaller, altcoin X’s dollar value of a one-tick move doubles that of the bitcoin futures, thanks to its large contract size. As a result, the dollar value of altcoin X futures moves with a magnitude of more than 10 times larger than bitcoin; its daily P&L is thus much more volatile than that of the bitcoin futures.
The main takeaway is to plan the risk and reward cautiously before entering any futures positions.
The Lifespan of a Crypto Futures Contract
Every futures contract expires on a certain date, and a futures trader needs to manage contract expiration. There are three choices regarding futures expiration:
Offsetting the Position or Liquidation
The most common way of exiting a trade is through offsetting or liquidating a position before expiration. To offset a position, a trader needs to implement an opposite and equal transaction to neutralise the trade.
For example, if a trader shorts two bitcoin futures contracts expiring in June, they will need to buy two bitcoin futures contracts expiring on the same date. The difference in price between the trader’s initial position and the offset position indicates the profit or loss on the trade.
Traders can avoid the final delivery by ending the contract before expiration. In fact, most futures contracts do not lead to delivery, since making or taking delivery under the terms of a futures contract is usually inconvenient and costly. Despite intending to buy or sell the underlying asset, hedgers tend to offset the futures position and then buy or sell the asset in the usual way.
Rolling Over a Crypto Futures Contract
If a trader prefers to maintain their market exposure with the futures contract, they can roll it forward. A trader will simultaneously offset their current position and establish a new position in the next contract month.
For example, if a trader were to long two bitcoin futures contracts that expire in March, they can roll by selling the two March contracts and buying two May (or later) contracts.
Settling a Crypto Futures Contract
If a trader neither offsets nor rolls over their position, the contract expires and they proceed to settlement. The party with a short position is obligated to deliver the underlying asset under the settlement method specified in the contract.
Why Trade Crypto Futures?
Futures trading mainly serves three purposes: hedging, speculation, and arbitrage.
Hedging
As mentioned, futures are originally designed for hedging risk. The risk could be associated with price fluctuations in various markets, such as commodities like oil and corn, foreign exchange rates, or the overall stock market.
The most ideal case is a perfect hedge, where a risk can be completely eliminated. In essence, a company hopes that the gain or loss on the futures position can be fully offset by the gain or loss on the sales of commodities, for example. Of course, it is nearly impossible to achieve in practise, but individuals and firms still aim to neutralise the risk as far as possible.
Speculation
If a trader expects the market to rally, they might long a futures contract; if a trader expects a coming plunge, they can sell a futures contract. In comparison to directly buying the underlying asset, traders can magnify their gains by increased exposure through leverage; but it also means they can suffer much greater losses, as well.
For example, suppose a trader buys a futures contract on a stock with a contract multiplier of 1,000 that requires an initial margin of $4,000. If the contract price is $70, the leverage of that futures contract amounts to ($70 x 1,000/$4,000) = 17.5 times. If the price rallies by 10%, the trader’s gain is magnified by 17.5 times to 175%. Similarly, if the price plunges by 10%, their loss will also be magnified by the same multiple.
Arbitrage
If a trader identifies any significant price discrepancy between the futures market and the underlying asset market, they can earn the price differential by simultaneously executing opposite trades in the two markets. This is also known as arbitrage.
Trading Futures on the Crypto.com Exchange
Explore Top Spot, Futures, and Perpetual Markets with the Crypto.com Exchange and choose from monthly and quarterly expiry dates for futures contracts. Sign up for a free account here.
Due Diligence and Do Your Own Research
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