In conventional future contracts, profits and losses are simple and proportional to price movements. However, inverse futures contracts involve a more complex relationship between the underlying asset, usually a cryptocurrency, and the fiat money (the contract).
This guide explores inverse futures contracts, including their advantages and associated risks. We also compare them with linear futures contracts to understand their underlying characteristics.
What are Inverse Futures Contracts?
As a new breed of derivative, inverse futures contracts enable traders to bet on the future price fluctuations of cryptocurrencies like Bitcoin. Their uniqueness lies in the fact that they’re settled and margined in the underlying crypto, while their value is quoted in traditional currencies like USD or stablecoins like USDT.
This inverse relationship produces a unique dynamic whereby the price swings of the underlying cryptocurrency inversely link the profit and loss (PnL).
How Inverse Futures Works: An Illustration
Starting with an entrance price of $60,000 and an exit price of $65,000, a trader signs a BTC/USD inverse futures contract. Though the outcome is in the base cryptocurrency (BTC), the profit calculation depends on the fluctuation between the entry and exit prices.
This non-linear relationship implies that BTC is needed less to cover the margin. Profit in an inverse futures contract is computed using the formula:
Profit (BTC) = 1/Entry Price (USD) – 1/Exit Price
With a 1 BTC position size, for instance:
Profit (BTC) = 1/60000 – 1/65000 × 1 = 0.00000128 BTC
This profit computation emphasizes the inverted character of the contract, in which an increase in the USD price of BTC causes a drop in the BTC amount needed for margin, therefore producing a profit in BTC.
Benefits of Inverse Futures Contracts
Inverse futures contracts offer several advantages
Extended Stack-Building
The opportunity to reinvest gains into long-term Bitcoin holdings is one of the main benefits of inverse futures contracts. Thus, miners and long-term holders steadily build their crypto stack over time.
Use in Bull Markets
Inverse futures contracts grant traders several leveraging opportunities during bull cycles. Long-position traders in inverse contracts can maximize their gains when the underlying Bitcoin price rises.
Hedging
Traders can guard their holdings against possible losses by holding and investing in crypto assets and concurrently employing inverse futures contracts. This functionality allows them to keep their exposure to the Bitcoin market without turning their holdings into stablecoins, enhancing their capacity for risk control.
Risk Factors
While they offer several trading benefits, inverse future contracts also have disadvantages.
Liquidity Risk
Any financial market depends critically on liquidity. Hence, inverse futures contracts are not unique. Liquidity can dry up during market stress or low trading activity, increasing slippage and making trading at desired prices more difficult. Thus, trading efficiency and general profitability may suffer.
Risks associated with Counterparty
Since they are usually traded on platforms or exchanges, inverse futures contracts are subject to counterparty risk, whereby the platform or exchange defaults or runs afoul of finances. Should the platform go bankrupt, traders might lose their outlay of money.
Inverse Future Contracts Vs. Linear Futures Contracts
Inverse futures contracts and linear futures contracts have their unique characteristics.
Settlement and Margin Coverage
In linear features contracts, agreements are settled and margined in stablecoins or fiat money, such as USD or USDT. Calculating profit and loss in the same currency helps traders grasp and control their holdings.
Conversely, inverse futures contracts have their contract value denominated in fiat money while settled in the underlying cryptocurrency, say BTC. While it presents unique benefits in reinvesting earnings and using them in bull markets, this inverse relationship results in a more difficult computation for profit and loss.
Trading Adaptability
Linear features contracts permit settlements in stablecoins across several futures markets, offering flexibility. Since traders do not have to acquire the underlying BTC to support their futures contracts, it becomes easy to calculate profits, which helps improve financial planning and analysis.
Despite their complexities, inverse futures contracts allow traders to create long-term crypto stacks and hedge positions without turning holdings into stablecoins. This factor can be invaluable for long-term investors and miners hoping to gather more BTC.
Final Thought
Inverse futures’ unique structure helps traders with long-term stack-building, leverage in bull markets, and efficient hedging. These contracts, however, come with significant challenges, including counterparty risks, market volatility, and liquidity issues. For those ready to seize the benefits and challenges of the evolving crypto market, inverse futures contracts remain a fascinating choice.
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