Making money trading crypto was easy in 2017. HODLing was the best strategy. The traders (as opposed to “investors”) could 2-3x their money within days, sometimes even by randomly picking coins.
The picture is dramatically different in 2018. With the crypto marketcap down about ~85%, HODLing hasn’t really been effective. Moreover, when the entire asset class is in a downtrend, spot trading (i.e. buying and selling actual crypto assets) is unlikely to yield profits. Navigating bear markets profitably requires you to have derivatives in your trading arsenal because derivatives can enable you to make money in both rising and falling markets.
Derivatives can seem intimidating to the uninitiated. But like all things in finance, the underlying thought process is fairly straightforward and intuitive. It is the jargon which unnecessarily complicates things. Don’t believe me? Read on and decide for yourself.
In this article, I will explain the intuition and workings of derivatives as applied to cryptocurrencies. While I’d only cover the basics, by the end of this article, you should know enough to start dabbling in crypto futures trading.
What are Derivatives?
A derivative is a type of financial instrument that derives its value from an underlying asset or group of assets. The derivative itself is essentially a contract between two parties and it’s price is driven by fluctuations in the underlying asset.
As I mentioned above, when trading derivatives, you don’t actually buy or sell the underlying asset. Instead you trade an instrument whose price is linked to the underlying asset.
What is the biggest implication of this design? The constraint in supply of the underlying has no bearing on how many derivative contracts you can create on it. For e.g. bitcoin supply is capped at 21 million, but we could still have theoretically infinite number of derivative contracts on bitcoin. This dynamic is quite evident in other mature asset classes (e..g. stocks), where the size of derivative markets tend to be 4-5x of the underlying spot market.
Derivatives come in multitude of designs and flavours, viz. forwards, futures, options and swaps. As far as cryptocurrencies are concerned, currently only futures markets are liquid. Crypto options trading is in nascent stages and is expected to grow rapidly over the next two years.
In part 1 of this article, I will only cover crypto futures, and crypto options would be discussed in part 2.
What is a Futures contract?
Futures is an agreement between two parties to buy/ sell an asset (e.g. bitcoin) at a predetermined future date and price. Let’s take an example. Bitcoin is currently trading at $3200 and you think it will bounce and go to $3500 by December 31, 2018. In contrast, I am little bearish. So, we get into a contract, which says you will buy 1 bitcoin from me at $3300 on Dec 31.
On Dec 31, 2018 price of bitcoin turns out to be $3400. Here’s what I will do: buy bitcoin from market at $3400 and sell it to you for $3300 and thus locking in a loss of $100. Conversely, you will pay me $3300 for 1 bitcoin and immediately sell it in the market, pocketing a profit of $100. Let’s unpack what’s going on here:
- Your profit = My loss. This will always be true for all derivatives, making them a zero-sum game.
- At the maturity of the contract, bitcoin was exchanged. Such a contracts is known as a physically-settled contract. The other alternative is to simply exchange the profit/ loss, i.e. we could have avoided the buying/ selling of bitcoin if I had simply given you $100 to settle our contract. That would make it a cash-settled contract.
- The price of the futures contract converged to spot price at the maturity of the contract. This is the defining trait of a futures contract and helps in their pricing.
- At any time before its maturity, price of a futures contract is linked to the spot price through a little complex equation. For simplicity, for now, we can work with
futures price = spot price + basis
- In our bet above, you made a profit when bitcoin price went up. So, you were long the bitcoin futures. Your profit/ loss equation is
𝚷Long = Bitcoin_Futures_PriceNow – Bitcoin_Futures_PriceEntry
I was short and would have made profit if bitcoin went down. My profit/ loss equation is
𝚷Short = -1 x (Bitcoin_Futures_PriceNow – Bitcoin_Futures_PriceEntry)
Now that we know how Futures work, let us understand how the contracts are created. Note that entering into the contract doesn’t require any upfront payment. Consequently, each party in the contract is required to trust that, if need be, its counterpart will pay up at the time of contract settlement. In the centralised world, this problem is solved by introducing a trusted intermediary, i.e. the exchange. With this, both the parties now need to trust only the exchange and not each other.
This is how the futures contract works. The exchange requires each party to post a collateral (which is popularly known as margin) for entering into a futures contract. Margin amount should be such that it is able to cover loss from the trade. As we saw in the example in the previous section, in cash-settled futures contract, only the profit/ loss needs to be exchanged between the two counter-parties in the contract. Thus, margin for entering a futures contract is typically small relative to the size of the position. This results in leverage, we will get to that in a bit.
Now you must be wondering what if the margin a party posts is not sufficient to cover its loss on the futures position. This is handled by the exchange by periodically checking ‘marked-to-market’ PnL of each trader. Essentially, the exchange checks that if a trader closes his position at the current market price of the futures, will his margin be enough to cover his losses. If not, the exchange asks the trader to top-up his margin, failing which his position is liquidated – closed at the current market price.
This liquidation process brings to fore another important function of the exchange – providing liquidity. Recall that a futures contract always has two counter-parties, with the profit of one party being always equal to the loss of the other party. Going back to our bitcoin futures example – let’s say bitcoin price shoots up, and the margin in my short position is completely eroded and the exchange liquidates my position.
But your long position is profitable and you don’t want to be forced into closing it. This is where the exchange liquidity comes into picture. The exchange is able to find someone else to take my place and become your counterpart in the futures contract, so that you can continue holding your long position.
Leverage is the most powerful feature of futures as it enables traders to take bigger positions with small amount of capital. The bitcoin futures contract that you and I had entered had the position size of $3300. If the exchange margin requirement is 10%, then we would need to have only 10%*$3300 = $330. Said another way, with just $330, your returns would be as if you had $3300. This 10x multiplier to your returns is the leverage in the futures contract.
So, we can now write two relations.
- Leverage = 1/ Exchange_Margin_Requirement. Lower margin requirement means higher leverage.
- Return on your money = Leverage x 𝚷futures . So, leverage amplifies your returns, be it profits or losses. Hence, it is a double edged sword and must be used carefully.
Ready to roll?
If you have fully understood the concepts introduced in this article, then you’d hopefully no longer find cryptocurrency futures intimidating. I’d recommend getting hands-on experience on a mock trading platform, like the Delta Exchange Testnet, before trading with real money. Futures can be a powerful addition to your trading tools if you know how to use them. In the second part of this series, I will help you tame options.
Disclaimer: Opinions in the article of the author may or may not reflect the opinions of Coin Crunch India. All the information in the article is for educational purposes only, and should not be taken as a Financial advise. Coin Crunch India will not be responsible for any loss or damages occurring by relying on the information in the article.
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