Summary
Bitcoin futures contracts are a type of derivative similar to traditional futures contracts. The two parties agree to buy or sell a fixed amount of Bitcoin at a specific price on a certain day. Through futures contracts, traders can both speculate and hedge losses. Hedging is a common practice among miners and can effectively cover operating costs.
Contracts are a great way to diversify your portfolio, leverage your trading, and stabilize your future income. To explore advanced strategies with contracts, take a look at carry trades. If executed correctly, forward carry and cross-platform carry can create some low-risk trading opportunities.
Introduction
Bitcoin futures contracts are an alternative investment opportunity for ordinary coin holders. For more complex products, you need to have a deep understanding of their mechanisms in order to conduct safe and reliable transactions. Although the method of use is quite difficult, the contract provides an effective way to lock in prices through hedging and profit from market declines through short selling.
What is a Bitcoin Contract?
Bitcoin futures contracts are financial derivatives similar to traditional futures contracts. In short, two parties agree to buy or sell a fixed amount of Bitcoin at a specific price (forward price) on a certain day. If you go long (agree to buy) a Bitcoin futures contract, and the mark price on the expiration date is higher than the forward price, you can make a profit. The mark price is an estimated fair value based on the spot price of the asset and other variables. We will discuss this in more detail later.
If the mark price on the expiration date is lower than the forward price, the contract loses money and the short position gains money. A short position is created when a trader sells a borrowed asset or his own asset in anticipation of a price drop. When the price drops, the trader buys the asset back, earning a profit. Contracts can be settled by physically exchanging the underlying asset or more commonly by cash.
Why use Bitcoin contracts?
One of the main uses of Bitcoin contracts is that buyers and sellers can lock in future prices. This process is called "hedging." Contracts have always been a hedging tool in commodity markets. Producers in commodity markets need stable income to cover various costs.
Traders can also use contracts for speculative purposes. Using long and short positions, you can predict market trends and take a chance. In a bear market, short positions may still be profitable. There are also many possibilities for arbitrage trading and other complex trading strategies.
Advantages of Trading Bitcoin Futures
Hedging
Hedging may seem to play a bigger role in physical commodity markets, but it also applies to cryptocurrency markets. Bitcoin miners, like farmers, have operating costs and want to get a fair price for their products. Hedging can work in both the contract and spot markets. Next, let's take a look at how it works.
Futures Contracts
Bitcoin miners can short futures contracts to protect their Bitcoin holdings. When the futures contract expires, the miners must settle with the other party to the contract.
If the Bitcoin price in the contract market (mark price) is higher than the forward price of the contract, the miner should pay the difference to the other party. Conversely, if the mark price is lower than the forward price of the contract, the other party holding a long position should pay the difference to the miner.
Spot Market
On the day when the futures contract expires, miners sell Bitcoin in the spot market. Bitcoin is sold at the market price, which is close to the mark price of the contract market.
However, spot market transactions will effectively offset any gains or losses in the contract market. The sum of the two is the hedging price that miners hope to obtain. Below we combine the two steps and illustrate them with data.
Combining futures contracts with spot trading
The miner shorts a 3-month contract for 1 Bitcoin at $35,000. If the mark price on the expiration date is $40,000, the miner loses $5,000 at settlement, and the difference is paid to the long side of the contract. At the same time, the miner sells 1 Bitcoin in the spot market, and the spot price is also $40,000. The miner receives $40,000, which makes up for the $5,000 loss, and the remaining $35,000 is the hedge price.
Leverage and Margin
Margin trading is very attractive to investors. It allows traders to borrow funds and establish positions that exceed their financial capacity. Small price changes are magnified, and the larger the position, the higher the profit. The risk of this mechanism is that if the market trend goes against the direction of the position, the principal is likely to be quickly forced to close.
The leverage of a trading platform is usually displayed as a multiple or percentage. For example, 10x means the principal is multiplied by 10. Therefore, using 10x leverage on $5,000 is equivalent to trading $50,000. When using leveraged trading, the principal to cover losses is called "margin". Specific examples are as follows:
If you buy 2 Bitcoin quarterly futures contracts at $30,000 each. The exchange allows trading with 20x leverage, so only $3,000 of principal is needed. This $3,000 is used as margin, and is deducted by the exchange in case of losses. If the loss exceeds $3,000, your position will be forced to close. Divide the leverage ratio by 100 to calculate the margin ratio. 10% margin corresponds to 10x leverage, 5% corresponds to 20x leverage, and 1% corresponds to 100x leverage. This ratio represents the room for the contract price to fall. Once it falls to the lower limit, the contract will be forced to close.
Portfolio Diversification
Using Bitcoin futures allows you to diversify your portfolio and adopt new trading strategies. We recommend building a balanced portfolio by including different tokens and products. The appeal of futures lies in the fact that they offer a variety of trading strategies that break the limitations of long-term holding. In addition, low-risk arbitrage trading strategies with lower profit margins can also reduce the overall risk of the portfolio. We will discuss these strategies more later.
Bitcoin Futures on Binance
Although they are all futures contracts, there are differences in details. The contract products of different trading platforms differ in terms of mechanism, expiration date, pricing and fees. At present, the main difference between various Binance contract products lies in expiration date and funding fee.
expiry date
So far, we have only covered contracts with a clear expiration date. Binance’s futures exchange offers quarterly contracts, while other exchanges also offer monthly and semi-annual (expiration date) contracts. The expiration date is clear from the contract name.
Binance's Bitcoin quarterly contracts follow the following calendar cycles: March, June, September, and December. The BTC/USD 0925 quarterly contract will expire on September 25, 2021 at 16:00:00 (UTC).
Another popular option is to trade perpetual contracts, which have no expiration date. Perpetual contracts have different profit and loss treatment compared to quarterly contracts, and also charge funding fees.
Funding
When buying Bitcoin quarterly contracts on Binance, you must deposit sufficient margin to cover potential losses. However, this potential loss only needs to be paid when the position is forced to close or the contract expires. In the case of perpetual futures contracts, a funding fee needs to be paid/collected every eight hours.
Funding fees are peer-to-peer payments between traders. These fees prevent the forward price of Bitcoin perpetual futures contracts from deviating from the mark price. The mark price is close to the spot price of Bitcoin, but it is designed to avoid unfair forced liquidations during volatile market conditions.
For example, a one-time transaction in the spot market is likely to temporarily increase the price by thousands of dollars. This volatility may cause the contract position to be forced to close, which makes it difficult to reflect the true market price. The content highlighted in red in the figure below is the funding rate, and the expiration date is next to it.
If the funding rate is positive, it means that the price of the perpetual contract is higher than the mark price. When the contract market is bullish and the funding rate is positive, long traders should pay funding fees to short traders. If the funding rate is negative, the price of the perpetual contract is lower than the mark price. At this time, shorts pay fees to longs.
The concept of funding rate is relatively complex. Please visit the Binance Futures Funding Rate Introduction for more details.
Currency-based contracts and U-based contracts
Binance offers two options for futures trading: Coin-margined futures, which use crypto as margin, and U-margined futures, which use BUSD/USDT as margin. Both types of futures can be perpetual futures, but there are slight differences between the two.
Coin-based contracts must use the underlying assets of the contract as collateral in the contract margin account. U-based contracts allow the use of cross-collateral. This feature allows users to use the cryptocurrency assets in the spot wallet as collateral to borrow USDT and BUSD at 0 interest.
Miners who want to hedge their Bitcoin positions generally use coin-margined contracts, which are settled in cryptocurrencies without having to convert Bitcoin into stablecoins, thus avoiding the need to introduce extra steps in the hedging process.
How to trade Bitcoin futures contracts?
To trade Bitcoin futures contracts on Binance, all you need to do is create an account and deposit a small amount of funds. Here is a step-by-step guide to start trading Bitcoin futures contracts:
1. Create a Binance account and enable 2FA (two-factor authentication). If you already have an account, be sure to enable two-factor authentication in order to deposit funds into your futures account.
2. Buy BUSD, Tether (USDT), or other supported cryptocurrencies to trade futures. The easiest way to do this is to use a debit or credit card.
3. Go to the Bitcoin Contract Overview and select the type of contract you wish to purchase. Select coin-based or U-based contracts, and whether it is a perpetual contract or a contract with a set expiration date.
4. Choose a reasonable leverage ratio. You can do this to the right of the [Full Position] button in the trading UI. Remember: after increasing leverage, the risk of forced liquidation will increase even with a small price fluctuation.
5. Please select the quantity and type of order, then click [Buy/Long] or [Sell/Short] to establish a Bitcoin contract position.
For detailed instructions, please read The Ultimate Guide to Binance Futures Trading.
Bitcoin Contract Arbitrage Trading Strategy
Above, we covered the basics of long and short trading, but there are other ways to trade. Futures contracts are similar to the Forex market, and carry trading strategies have a long history. Traders use these techniques in traditional markets, and they are equally applicable to the cryptocurrency market.
Cross-Exchange Platform Arbitrage
Whenever different cryptocurrency exchanges offer futures contracts at different prices, there is an opportunity for arbitrage trading. Buy a contract on a cheaper exchange and then sell another contract on a higher-priced exchange to earn the difference.
For example, let's say Binance's BTC/USD 0925 quarterly contract is $20 cheaper than on other exchanges. You can arbitrage by buying a contract on Binance and then selling another contract on an exchange with a higher price. Of course, prices can change rapidly under the influence of automated trading bots. You have to time it perfectly, as the spread can disappear at any time. Don't forget to factor in the fees you have to pay when calculating your gains.
Positive Arbitrage
In futures trading, positive arbitrage is a market-neutral position and is not new. A market-neutral position is buying and selling an asset at the same time and in equal amounts. In this case, traders can go long and short the same futures contract at the same time, regardless of price. Compared with traditional commodity contracts, cryptocurrency contracts can create more substantial profit margins through positive arbitrage.
Cryptocurrency contracts trade less efficiently than traditional markets, which increases arbitrage opportunities. To successfully implement this strategy, you should find a point where the Bitcoin spot price is lower than the contract price.
After determining the point, a short position is established with a futures contract, and the same amount of Bitcoin is bought in the spot market to cover the short position. After the contract expires, the purchased Bitcoin can be used to settle the short position, earning the previously found price difference in an arbitrage manner.
Why does this opportunity exist in the first place? The reason is that although there is no money to buy Bitcoin at the moment, people believe that the price will rise and are willing to pay a higher contract price. For example, if you believe that Bitcoin will be worth $50,000 in three months, and the current price is $35,000.
You are short of funds temporarily, but the funds will be available in three months. At this time, you can establish a long position with a small premium of $37,000, which is scheduled for delivery in three months. The essence of a positive arbitrageur is to hold other people's Bitcoin for a fee.
Summarize
Bitcoin futures trading has evolved from a tried-and-tested product in the traditional financial sector, and has finally taken root in the cryptocurrency space. The cryptocurrency futures market is currently very popular, and trading platforms with high trading volume and strong liquidity are everywhere. However, trading in the Bitcoin futures market involves high financial risks. Before opening a trade, it is important to fully understand how futures trading works.
