How Bitcoin Futures Trading Works: Principles and Pros & Cons

What Are Futures?

Futures are standardized contracts between two parties to buy or sell a specific asset at a predetermined price on a specific future date and time. Typically, futures contracts are traded on futures exchanges. These contracts specify the quality, quantity, and price of the underlying asset. There are several reasons for entering into futures contracts. First, since the parties agree to trade at a specific price at a specific point in the future, the buyer of the underlying asset is protected against price fluctuations in the market. Because they have committed to buying or selling at a specified price, the contract holder may realize either profits or, in some cases, losses.

Most contracts in the financial sector grant the contract holder the right to do something. However, futures contracts impose both the 'right' and 'obligation' on both parties to fulfill the terms of the contract. Generally, futures contracts require physical delivery of the related asset, while another type of futures contract is settled in cash. This distinction is important as it determines how the contract will be executed at maturity.

Futures contracts serve multiple purposes in financial markets. They enable price discovery, provide liquidity, and allow market participants to hedge against adverse price movements. For institutional investors and commercial entities, futures contracts are essential tools for risk management and strategic planning. The standardized nature of these contracts ensures transparency and reduces counterparty risk, as exchanges act as intermediaries to guarantee contract fulfillment.

How Do Futures Contracts Work?

Futures contracts involve two parties: a buyer and a seller, allowing them to lock in costs and trade before recovering the asset. This mechanism provides certainty in uncertain markets and enables strategic planning for both parties.

Assets used in futures contracts on futures exchanges include various commodities and financial instruments. To better understand this concept, let's assume there is a farmer who wants to sell a large quantity of corn in the next harvest season. Although the corn has not yet been produced, the farmer wants to secure an appropriate price for the future. The farmer then finds a buyer willing to pay the current market price or a similar price. In this case, the seller and buyer can enter into a futures contract at a specific price. This protects both the seller and buyer from significant price fluctuations.

Futures contracts typically involve two main types of traders: hedgers and speculators. Hedgers are interested in the underlying asset and seek to hedge against price fluctuation risks, while speculators do not actually use the asset fixed in the futures contract. Instead, speculators buy futures to later sell them to stakeholders at a profit. This dual participation creates market depth and liquidity, ensuring that contracts can be easily bought and sold.

In futures contracts, participants can enter either long or short positions. A long position means one party promises to buy the asset at a specific date and time, while a short position means promising to sell the asset at a specific date and price. These positions allow traders to profit from both rising and falling markets, providing flexibility in various market conditions.

What Are Bitcoin Futures?

Like traditional futures contracts, Bitcoin can also be traded through futures contracts, bringing the innovative world of cryptocurrency into established financial markets.

Simply put, Bitcoin futures are contracts where two parties agree to buy or sell Bitcoin at a specific future price and date. In late 2017, major financial institutions introduced Bitcoin futures contracts, marking a significant milestone in cryptocurrency adoption. These contracts, traded on electronic trading platforms, are cash-settled. Bitcoin futures are based on Bitcoin reference rates that aggregate prices from multiple sources.

Bitcoin futures trading does not involve actual Bitcoin. Since futures are cash-settled contracts, Bitcoin itself is not involved in the transaction. Like other futures contracts, investors only predict Bitcoin prices without actually buying or selling the underlying cryptocurrency asset. However, if Bitcoin prices are expected to rise, investors can take a long (buy) position, or if they hold Bitcoin, they can take a short position to reduce potential losses.

It is important to note that the price of Bitcoin futures contracts is proportional to the Bitcoin price. Therefore, Bitcoin futures trading is an alternative to spot trading, which involves actually buying or selling the underlying cryptocurrency asset. This relationship ensures that futures prices track the underlying asset while allowing for basis differences due to market conditions.

Spot trading offers only basic trading orders such as buying low and selling high, and tends to profit during bull markets. On the other hand, Bitcoin futures trading allows for profits in both bull and bear markets through trading and leverage utilization. This flexibility makes futures an attractive instrument for sophisticated traders seeking to capitalize on market volatility in both directions.

Types of Bitcoin Futures

Currently, there are several types in the Bitcoin futures market, with different platforms offering various derivative trading options. The most common products are standard futures contracts and perpetual swap contracts. These two products are popular derivatives commonly traded in today's investment industry. However, since these two products have different characteristics, they must be clearly understood before investing.

Futures Contracts vs Perpetual Swap Contracts

The essential differences between Bitcoin perpetual swap contracts and Bitcoin futures contracts are as follows:

Bitcoin perpetual swaps have no expiration date in the contract. They are essentially infinite and endless. On the other hand, Bitcoin futures contracts have an agreed expiration date. Therefore, there is a period during which the contract must be honored, typically no more than one month maximum.

Since perpetual swaps have no expiration date, exchanges use a price synchronization system called the funding rate mechanism. This mechanism stabilizes short and long positions in perpetual swaps by adding or subtracting from trades. It requires fees that help maintain short and long positions in perpetual contracts, creating an equilibrium between buyers and sellers.

Another characteristic of perpetual swaps is that they generally reflect trends in the spot market, which can be attractive to cryptocurrency traders. However, volatility is a major risk here. As a result, the price of perpetual swap contracts tends to deviate from spot prices when market volatility is high. This deviation creates arbitrage opportunities but also increases risk for position holders.

Similar to Bitcoin futures, perpetual swaps are a trading method that does not require continuous resetting of long and short positions. This ensures that the price of perpetual swaps matches the spot price through coin swaps between traders. Unlike Bitcoin futures, perpetual swaps have no expiration date, so there is no need for automatic price adjustment processes related to contract terms and related assets. This allows traders to trade more flexibly without constantly renewing contracts, making them particularly popular among active traders.

How Do Bitcoin Futures Work?

The operating principle of Bitcoin futures is the same as that of general futures contracts. Additionally, trading through centralized exchanges such as major platforms can help avoid large-scale risks, providing a more secure trading environment with established regulatory frameworks.

To better understand this, let's assume you purchase Bitcoin with a $40,000 futures contract to be settled in two months. According to the futures contract, if it trades at $50,000 in two months, you will make a profit of $10,000 per contract. However, if it falls to $30,000 by then, you will incur a loss of $10,000 per position. This example illustrates the leveraged nature of futures trading, where both gains and losses are magnified.

If you think the price will fall, you can sell a futures contract at $40,000 under the same conditions. This means that even if Bitcoin falls to $30,000 by the expiration date, you can sell it at $40,000, earning a profit of $10,000. At this time, Bitcoin must be above $40,000 at expiration for the short position to be profitable.

To fulfill these obligations, we deposit money called 'margin'. Margin refers to the minimum collateral that must be held in an account to execute a trade. The more money you put into a trade, the higher the margin required by the exchange to complete the trade. This margin system protects both the exchange and traders from excessive losses.

Typically, margin ranges from 5% to 15% of the underlying asset value, though this can vary based on market conditions and exchange policies. Higher volatility assets may require higher margin percentages to account for increased risk.

Leverage

The higher the leverage, the more exposed you are to higher profits or losses. Additionally, the amount you can trade depends on the amount of available margin. For example, certain major exchanges offer leverage of up to 125 times the trading amount. Leverage determines the volatility level of the trade and significantly impacts risk management strategies.

While high leverage can amplify profits, it equally amplifies losses, making risk management crucial. Traders must carefully consider their risk tolerance and market conditions when selecting leverage levels. Professional traders often use lower leverage to maintain sustainable trading strategies, while more aggressive traders may utilize higher leverage for short-term opportunities.

Pros and Cons of Bitcoin Futures

Understanding these advantages and disadvantages is essential for making informed trading decisions. The benefits of leverage and flexibility must be weighed against the risks of amplified losses and market complexity. Successful futures traders typically develop comprehensive strategies that account for both opportunities and risks.

Relationship Between Bitcoin Futures and Bitcoin Price

Bitcoin futures contracts are agreements to buy or sell Bitcoin at a predetermined price on a future date. The price of these contracts is expected to move in tandem with the actual market price of Bitcoin, but various factors during the contract period can cause divergence from the actual price. This can affect the current Bitcoin price, causing it to rise or fall.

This typically generates volatility rapidly. For example, when large companies like major corporations invest more in Bitcoin or when major countries such as certain nations ban cryptocurrency trading, these events create significant market movements. Due to supply and demand issues regarding Bitcoin prices, the spread of Bitcoin futures contracts can expand or contract, reflecting changing market sentiment and expectations.

Another price movement is known as a gap. This is a period when no trading occurs and there is no price data during this time. Unlike the broader cryptocurrency market that trades 24/7, traditional platforms have specific trading hours, which can only be traded on platforms with established schedules. These gaps can create opportunities for traders but also introduce additional risk when markets reopen with significant price differences.

Where Can You Trade Bitcoin Futures?

You can trade Bitcoin futures on various platforms, whether they are regulated exchanges or centralized cryptocurrency exchanges. The choice of platform depends on factors such as regulatory requirements, available leverage, trading fees, and user interface preferences.

U.S. Exchanges

• Chicago Board Options Exchange (CBOE): CBOE was the first U.S.-based exchange to offer Bitcoin futures contracts. It began offering products on December 10, 2017, marking a historic moment for cryptocurrency integration into traditional finance. A week later, another major exchange followed suit.
• Chicago Mercantile Exchange (CME): Another platform where Bitcoin futures trading is available. It implements a Bitcoin reference price, which is the volume-weighted average price of Bitcoin supplied from multiple exchanges, usually calculated between 3 PM and 4 PM daily. CME's Bitcoin futures contracts trade from Sunday through Friday, 5 PM to 4 PM (Central Time), and expire on the last Friday of each month. The CME platform is particularly popular among institutional investors due to its robust regulatory framework.

Korean Cryptocurrency Exchanges

• Major Korean Platform A: One of the largest cryptocurrency exchanges in Korea by trading volume. It supports a user-friendly interface and various cryptocurrencies, with futures trading capabilities. The platform has established itself as a trusted venue for both retail and institutional traders.
• Major Korean Platform B: A large exchange with a long history in Korea, providing spot and futures trading services for various cryptocurrencies. Its easy-to-use platform and high liquidity are distinctive features that attract a broad user base.
• Major Korean Platform C: Another popular exchange in Korea, offering futures trading options for Bitcoin and several other cryptocurrencies along with a secure trading environment. The platform emphasizes security and user protection.
• Major Korean Platform D: Korea's first cryptocurrency exchange, providing services to users based on reliability and stability. It also supports Bitcoin futures trading and has maintained a strong reputation in the market.

International Cryptocurrency Exchanges

• Leading Global Platform A: One of the popular platforms for seamless futures trading, offering advanced trading tools and competitive fees.
• Major International Exchange: As one of the world's largest cryptocurrency exchanges, it offers futures trading with various attractive features including margin leverage options. The platform provides comprehensive trading tools and educational resources.
• Prominent Trading Platform: Offers margin and futures trading with substantial leverage options. Users can utilize different leverage levels for Bitcoin and other cryptocurrency assets, with risk management tools integrated into the platform.
• Established Exchange and other platforms continue to expand their futures offerings, providing traders with diverse options.

Is Bitcoin Futures Trading a Good Choice?

There are many ways to start investing in Bitcoin, and currently, there is no perfect investment method that suits everyone. Bitcoin futures can be a good way to make money and participate in the cryptocurrency market with sophisticated strategies. However, at the same time, significant financial losses are possible, especially for inexperienced traders or those who fail to implement proper risk management.

Therefore, it is essential to thoroughly understand the advantages and risks of Bitcoin futures and choose the strategy that best suits your individual circumstances. Factors to consider include your risk tolerance, investment timeline, market knowledge, and available capital. Successful futures trading requires continuous learning, disciplined execution, and realistic expectations about potential returns and risks.

Before engaging in Bitcoin futures trading, consider starting with smaller positions, using stop-loss orders, and never investing more than you can afford to lose. Education and practice through demo accounts can help build the skills necessary for successful futures trading. Additionally, staying informed about market developments, regulatory changes, and technological innovations in the cryptocurrency space is crucial for making informed trading decisions.

FAQ

What is the basic principle of Bitcoin futures trading?

Bitcoin futures trading allows traders to speculate on BTC price movements without owning actual Bitcoin. Participants enter contracts agreeing on future BTC prices, enabling leverage trading, hedging, and profit generation from price volatility through standardized derivative contracts.

How does leverage work in Bitcoin futures trading?

Leverage allows traders to control larger positions with smaller capital, amplifying both profits and losses. For example, with 10x leverage, you can control a $10,000 position with just $1,000 margin. Higher leverage increases liquidation risk significantly if markets move against your position.

What are the advantages of Bitcoin futures trading compared to spot trading?

Bitcoin futures offer leverage to control larger assets with less capital, enabling amplified returns. They provide diverse trading strategies including hedging, shorting, and speculation. Futures also feature standardized contracts with transparent pricing and higher trading volume.

What are the main risks of Bitcoin futures trading?

Bitcoin futures trading carries significant risks including leverage amplification, which magnifies both gains and losses. Price volatility can lead to substantial losses exceeding initial margin. Liquidation risk occurs when positions move against traders, potentially wiping out entire accounts.

How do beginners start trading Bitcoin futures?

Choose a reputable platform, complete KYC verification, and deposit margin. Learn basic order types and contract rules. Start with small positions using low leverage (2-3x), set stop-loss orders, and practice with a demo account before trading with real capital.

What are the settlement methods for Bitcoin futures contracts?

Bitcoin futures contracts typically offer two settlement methods: physical delivery, where actual Bitcoin is transferred upon contract expiration, and cash settlement, where profits or losses are calculated based on the difference between contract price and spot price at expiration.

What is the difference between perpetual contracts and periodic futures contracts?

Perpetual contracts have no fixed expiration date and trade continuously, while periodic futures contracts have fixed delivery dates（weekly, bi-weekly, or quarterly). Perpetual contracts require funding rate adjustments instead of periodic settlement.

How to manage risk in Bitcoin futures trading?

Set stop-loss orders to limit losses, use appropriate leverage ratios, diversify positions, start with small amounts, and maintain adequate margin. Monitor market conditions closely and avoid over-leveraging to prevent liquidation.