There are three major ways to invest in cryptocurrencies; the spot market, forwards market and futures market. Futures investing which is our focus in this article is found in a variety of markets such as the stocks, commodities, currency and cryptocurrency markets but it is not for beginners. A lot of young investors are attracted to futures trading because of the possibility to earn an amplified return on investment by increasing their leverage on futures contracts.
What are Futures Contracts?
A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon price. That asset might be soybeans, coffee, oil, individual stocks, ETFs, cryptocurrencies and so on. Typically, futures contracts trade on an exchange.
It involves a party agreeing to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party to the contract agrees to provide it. Futures contracts are very similar to forwards contract but the difference between the two is that futures contracts are publicly traded and cannot be customized (They are standardized in their specified contract size and settlement procedures).
How do they work?
Futures contracts allow investors to secure a specific price and protect against the possibility of wild price swings that may be bullish or bearish. Let’s illustrate this:
If an investor believes that the price of Bitcoin is going to rally then the investor can get into a buy futures contract and when the price of Bitcoin goes up, depending on the margin and leverage used in the contract, the investor can make profit. Similarly, when the investor believes the price of Bitcoin will be bearish, which is the trend in recent weeks, the investor can also get into a sell futures contract and when the price goes down, depending on the margin and leverage used, the investor will also make a profit.
The double-edged sword of margin and leverage
Although interconnected, since both involve borrowing, leverage and margin are not the same. Leverage refers to taking on debt, while margin is debt or borrowed money a firm uses to invest in other financial instruments.
In futures trading, investors are allowed to borrow a substantial amount of money to play the market because it is the main way to amplify relatively small price movements to potentially translate to significantly high return on investments. Borrowing however has its risk. If markets move against your prediction, you could lose all the money you invested in the market.
Margin or Leverage is used to increase an investor’s buying power. An investor is required to put up only a fraction of the funds they would normally need to open a much larger position. This means rather than paying the full value of the position, you only need to pay a percentage of the position, which is called ‘initial margin’. While trading with high margin or leverage can be beneficial when the trade goes your way, it is also high-risk given the fact you can potentially lose your entire investment, if you are a retail investor. Let’s look at the scenario:
If a trader wants to place a futures buy contract worth $2,000 on Bitcoin which has an initial margin rate of 0.5%, the trader only needs to deposit 0.5% of the total value of the position, which in this case would be $10. If the trade goes against the trader, the trader can lose the entire $10 depending on how far away it goes from the trader’s prediction.
Should you be trading futures contract?
Well, before we can decide this, you need to know the risk associated with futures trading. They are as follows:
- Margin or leverage can be a double-edged sword as are amplified, but so are losses.
- Investors can lose more than the initial margin amount because of leverage.
- Timing is everything in futures trading. It’s not enough to know the market trends. You need to predict precisely when the market is going to go up or down, which is almost impossible and makes it a difficult venture to get into altogether.
Cryptocurrency futures trading is a high-risk, high reward endeavour. It is for experienced traders who have the knowledge to participate in the market. If you are an individual who cannot accept the total loss of your investment, then futures trading isn’t for you. If you are new and lack experience in the market, then futures trade is also not for you.
A lot of new traders see futures trading for cryptocurrencies as a get rich quick scheme but that is rarely the case. The market is highly volatile and it involves consistent monitoring of positions before deciding to take a position. This makes cryptocurrency futures trading a risky business to get into.