By Norah ODonnell
An inverse futures contract is a financial arrangement. It needs the seller to pay the buyer the difference between the agreed-upon price and the prevailing price upon contract expiration. On the contrary to conventional futures, the seller benefits from price drops.
Irrespective of the underlying crypto being traded, the contract value of an inverse futures contract is denominated in a fiat currency like the United States dollar of an established stablecoin like Tether (USDT). There is an inverse relationship between profit and loss (PnL) and the movement of the underlying crypto’s price.
A type of derivative, an inverse futures contract is valued in USD and settled/margined using the underlying crypto. For instance, the market price of the BTC/USD pair is determined in USD, while the profit and margin are calculated in Bitcoin (BTC).
How Does An Inverse Futures Contract Operate?
The nature of an inverse futures contract is non-linear. Whenever a trader goes long on the BTC/USD inverse future contract, they are shorting the USD. As the contract is inverse, the trader’s position is worth less in Bitcoin, and the higher the value of Bitcoin, the more it increases in relation to the dollar.
To understand how inverse futures contracts operate and all related calculations, let us use an example. It features the calculation of profit for a position in Bitcoin using inverse futures contracts.
Here is an extensive breakdown:
- Position size: 1 BTC
- Entry price (BTC): $62,000
- Exit price (BTC): $69,500
The user is trading an inverse BTC/USD futures contract with a 1-BTC position size. The calculation would mean the investor will make $7,500. Investors who want to benefit from the increasing asset values sometimes take ‘long’ positions, which means they are betting on price surges. When it comes to inverse contracts, investors who take a long position will gain from the underlying asset’s appreciation against the USD, in this case, Bitcoin.
Suppose an investor decides to take a position long in inverse contracts connected to Bitcoin/USD. The value of their Bitcoin holdings increases in conjunction with the price of the crypto. As a result, dollar holdings increase in value in line with the surge in the price of BTC.
The price of Bitcoin and the value of the inverse contracts denominated in US dollars are directly linked, offering investors an easy opportunity to profit from favorable market conditions.
Benefits Of Inverse Futures Contracts
Inverse futures contracts enable traders to build long-term sacks by enabling them to reinvest earnings into crypto holdings offer leverage in bullish markets for higher profits, and operate as effective hedging instruments without changing holdings into stablecoins such as USDT.
Here are the benefits of inverse futures contracts:
Long-Term Stack-Building
Trader profit can be reinvested directly into long-term crypto holdings via inverse futures contracts, valued and settled in crypto. It enables miners and long-term holders to build their crypto stack consistently over time.
Leverage In Bull Markets
During the bull markets, inverse futures contracts can offer traders leverage, allowing them to hike their profits when the value of the underlying crypto surges. For traders who properly forecast rising price changes, the leverage may boost profits.
Hedging
The traders can hedge their positions in the futures market without converting any of their holdings into stablecoins like USDT by holding and investing in crypto assets concurrently. This boosts risk management skills in futures trading by allowing traders to protect against potential losses while keeping exposure to the crypto market.
Risks Linked To Inverse Futures Contracts
Crypto traders dealing with inverse futures contracts need to consider liquidity concerns, counterparty risks, and market volatility.
Market Volatility
Inverse futures contracts might be extremely susceptible to fluctuations in the market, increasing profits and deepening losses. Quick changes in the underlying crypto’s price can cause traders to suffer massive losses.
Counterparty Risks
Trading platforms or exchanges are involved in inverse futures contract trading. If the exchange cannot pay its dues or becomes bankrupt, there is an opportunity for a counterparty default, which may result in traders losing most of their money.
Liquidity Risk
Liquidity issues may arise with inverse futures contracts, specifically during market stress or low trading activity. Decreased liquidity can result in increased slippage. This scenario can impact general profitability and make it challenging for traders to complete trades at the desired prices.