Thread by @AureliusBTC

I've been talking to a lot of traders who are great at calling price action direction, but don't fully optimize their potential gains by using anything other than XBTUSD & spot.

So here's a thread on futures:

Futures contracts are an instrument that allows you to speculate on the future price of an asset at a certain date, the expiry date.

They're mainly used by 2 groups of market participants:
1) Hedgers
2) Speculators

When the futures expire, the contract settles at spot price.

Virtually all major assets have futures contracts, but futures are particularly useful in commodities, as it allows people to hedge.

Producers of a raw commodity can hedge their risk of holding the asset by going short on the futures contract, but holding spot.

This locks in a certain price point for their commodity produced until the expiry date and hedges their exposure.

Bitcoin futures act a bit differently than futures on traditional assets.

Market participants who have spot exposure to BTC, but want to hedge it, such as miners, still all use futures.

However, the majority of futures is pure speculation since there is no consensus on how to properly value Bitcoin.

This leads to the contracts being used for price discovery, causing futures to have a large basis, which is the difference between futures & the spot price.

You've likely noticed this basis at some point -- During December, futures often traded at a 10-20% premium. This is called contango.

Contango is a situation where the futures price is above the spot price, since speculators believe the price of the asset will be worth more at the expiry date than the actual expected price of the asset.

Recently, we've seen futures trade under spot price, which is called backwardation, the opposite of contango.

So why does this basis occur?

A few reasons:
1) Speculators
2) Traders avoiding Bitmex funding fees on Bitmex's perpetual swaps
3) The ability to use leverage

As mentioned previously, expiry dates are key to futures, since futures settle at the *spot price* then. This is what ultimately drives the dynamics behind the contracts.

As the contract matures and starts to reach the expiry date, the basis should -- in a *rational* market -- shrink away until it eventually reaches spot price, as shown below.

So that's an overview of futures contracts and how they work..

They're relatively simple, but what does this mean in practical terms in terms of trading BTC?

When trading, you should always keep track of the futures prices. Your goal should be to utilize the basis to your advantage.

For example, if you are going to take a swing trade long, and futures are in backwardation, you should take the long on futures.

Why?

1) You won't pay funding fees for being long in a bullish market.
2) More importantly, if correct, you will GAIN the basis once futures revert back to the spot price, while also take advantage of the premium that should form.

The opposite applies to shorts, if you are bearish. However, in both case, you must be careful that you have enough margin to sustain the position in case the basis goes against you.

Example:

Someone shorts XBTU18 at $10k on futures, while in contango. The premium then rises to 10.4k, causing one to potentially stop out, even if the spot increase was negligible.

Using standard risk management on futures positions is still key to a successful trade.

So what about non-directional trades? This is something most traders rarely consider.

With crypto still being such an inefficient market, there are lots of arbitrage opportunities, specifically with futures.

For example, in May, XRPM18 contracts were trading at 10% premium compared to spot XRP.

One could short XRPM18 (futures) and long spot the equal amount, and made 10% risk-free if they held until settlement or until futures reverted to spot.

This is called cash and carry.

Another, more recent example, of reverse cash and carry:

XBTM18 contracts, which expire in 4 days were trading at 1% under spot yesterday.

Longing XBTM18 (futures), and shorting XBTUSD and waiting 4 days for the contracts to settle would yield a 1% net gain, with no risk.

Since crypto is an inefficient & irrational market, taking advantage of the basic arbitrage opportunities that exist creates nearly risk-free gains, and isn't something to be overlooked.

To summarize --

Futures allow you to speculate on the price of an asset at the expiry date, at which point the contract settles at the spot price.

Traders who have a firm grasp of how to utilize futures will easily increase their returns with the many opportunities they offer.