There’s an increasing number of exchanges, such as Binance, FTX, Bitfinex, Bybit, and Kraken, offering futures contracts trading. As volumes continue to increase, the industry is beginning to see an influx in retail traders experimenting with them.
So what are futures and why use them?
Essentially, a futures contract is an agreement to buy or sell an asset at a later date for a predetermined price. Initially connected to hard commodities, these complex instruments empowered the producers and sellers of items such as seeds oil and precious metals to lock in prices upfront—thereby offsetting potential financial risk. For this reason, futures contracts are also known as derivative instruments—objects whose value relies on an underlying asset.
Professional traders frequently utilize futures contracts for better positioning on both sides of the market. Sellers, known as shorts in the industry, hope for a price retraction resulting in a profit while buyers, or longs, bet on a price increase on the underlying asset.
Another benefit of futures contracts is that traders can decrease their stake without holding stable coins or fiat deposits on exchanges. Fiat money refers to any currency that is declared legal tender by a government but lacks intrinsic value. A strong example of fiat money is the United States Dollar, which as of 1970, is no longer backed by gold.
Futures Trading Differentiators
Futures trading operates in a state of equilibrium in that each trade of this nature needs a buyer and seller of the same maturity and size.
This, among other factors, vastly differentiates futures trading from spot and margin trading. A key differentiator in spot trading is that trade settlements take place simultaneously. As soon as the trade is initiated, the buyer gets cryptocurrency at the same time that the seller receives their fiat, stablecoin or other assets. In a futures transaction, both parties pledge a margin and neither party receives anything initially.
Additionally, futures trades do not happen in the same order book as other transactions such as spot trades, because the purpose of a futures trade is to postpone the settlement thereby causing futures prices to fluctuate from spot prices depending on market conditions. However, derivative exchanges usually create indexes, also known as ‘fair prices’, which are predicated on the average price of spot exchanges. If the margin between the futures price and the underlying fair price is too large, the exchange will forcefully close futures position. This practice prevents market manipulation.