What is a Futures Contract?

For those of you familiar with Bitmex, you have most likely heard the terms futures, perpetual swap contract, leverage, etc. But what do these mean?

A futures contract is simply an agreement between a buyer and a seller to exchange a good at a future date, at a set price. Hence the term “futures contract”. This implies that at a set point in time, the underlying asset will swap hands. During this time period, either party is permitted to sell their end of the contract, which allows for speculation. These contracts are traded in various markets for various underlying goods on exchanges around the world. In crypto, the most well-known contract is the XBTUSD Perpetual Swap Contract, which is tied to the Bitcoin vs. USD pair. But what does “perpetual swap” mean?

Well, a perpetual swap contract means that there is no date in the future at which the contract expires and must be settled. The buyer never actually has to buy, and the seller never actually sells. In a traditional futures contract, the value is established because the price is already agreed on, and each end of the bargain knows exactly what they’re getting. So what gives this contract value? What keeps the price in line with the underlying asset? Why trade it at all?

A perpetual swap market is maintained in value by requiring each trader to hold enough of the underlying asset (in our case, Bitcoin) to cover their orders. Note that while there is no actual exchange of U.S. Dollars to Bitcoin, each trader must have bitcoin in their account in order to purchase a futures contract position. This gives the underlying market inherent value, as there is something to base it on, even without the asset swap.

Funding Rates

In order to keep the contract in line with the actual value of the underlying asset, something known as a funding rate is used in conjunction with what’s known as a spot price. The spot price is the calculated broad market value of the underlying asset, in this case, Bitcoin. Bitmex uses a calculation that takes several different exchange prices into account in order to determine the spot price for their XBTUSD contract.

The funding rate is based upon the spot price, and the way it works is by forcing one side of the market to pay the other side if the price of the futures contract strays from the spot price. If the futures contract is worth more than the spot price, long positions (bulls) will pay short positions (bears) at a rate determined by the amount of variance between the spot price and the current price of the futures contract. If the futures contract is valued at less than the spot price, bears pay the bulls, and so the market is kept mostly equal.

Bitcoin Futures vs. Bitcoin

So why trade futures at all, instead of just trading the underlying asset? After all, on a normal market, we wouldn’t have to worry about a spot price, funding rate or any of the rest of it. The answer is leverage.

Leverage (also known as margin) is offered by futures exchanges in order to A) increase liquidity of the asset by increasing the number of contracts being traded, which is good for investors, and B) collect more fees on the increase in contracts. So what advantages does trading using leverage offer us, and what is it anyway?

Benefits of Leverage Trading

Leverage trading offers investors the ability to “leverage” their money and to buy and sell more contracts than they can afford, or want to store on the exchange. For example, if I deposited one Bitcoin onto a futures exchange, and entered a trade using 2x leverage with my full amount, I would be able to purchase 2 Bitcoin’s worth of futures contracts. For every 1% that the price moved in my favor, I would instead gain 2% of my original investment (1 Bitcoin), since I am gaining profit from the extra bitcoin that the exchange has “loaned” me. Sounds great right? The downside can be catastrophic if the investor is not careful.

Risks of Leverage Trading

See, the extra bitcoin that the exchange is lending you doesn’t actually exist, they cannot let you lose it in a bad trade. If a trader opens a position at 2x leverage, and the price moves against that trader with a 50% drop, his contract value would now be 1 Bitcoin, the amount he originally deposited. The problem is that if the price moves against the trader by any more, he will have lost more than the amount he is holding on the exchange. The exchange, of course, does not want to pay for additional losses, and so they perform what is called a margin call on the trader; they immediately liquidate his position, closing it at market value and taking from him the 1 BTC in value he has lost. This prevents that extra bitcoin that the exchange effectively created from thin air from being lost, as well as leaving the trader with a balance of zero, or 100% loss.

Now, 50% swings seem easy to avoid, but many exchanges offer leverage of up to 100X. At 100X leverage, a 1% move will either double the value of the initial investment or cause a complete loss. This can be incredibly dangerous.

The Verdict on Leverage Trading

Leverage trading can be an incredibly useful tool or a dangerous weapon. It is up to the individual to exercise caution when engaging in leverage trading. None of the information in this article is intended to be financial advice. Never invest more than you can afford to lose, and always consult a licensed financial advisor before making investment decisions.

Thank you for reading! If you’d like to trade using leverage, you can do so on Bitmex. Using this link will provide you with a 10% discount on trading fees for your first 6 months. Be careful, trade safely!