Many traders often express some relatively large misconceptions about trading cryptocurrency futures, especially on derivatives exchanges outside the realm of traditional finance. The most common mistakes include underestimating futures market prices, fees and the effect of liquidations on derivative instruments.
Let’s explore three simple mistakes and misconceptions that traders should avoid when trading crypto futures.
Derivatives contracts differ from spot trading in pricing and trading.
Currently, the total futures open interest in the crypto market is over $25 billion and retail traders and experienced fund managers use these tools to leverage their crypto positivity.
Futures contracts and other derivatives are often used to reduce or increase risk and, despite this common interpretation, are not actually used for degenerate gambling.
Some differences in pricing and trading are usually missed in crypto derivatives contracts. For this reason, traders should at least consider these differences when entering the futures market. Even derivatives investors well-versed in traditional assets are prone to make mistakes, so it is important to understand the current specifications before using leverage.
Most crypto trading services do not use US dollars, even though they display USD quotes. This is a great untold mystery and one of the pitfalls faced by derivatives traders which leads to additional risk and distortions when trading and analyzing the futures markets.
The pressing issue is the lack of transparency, so clients don’t really know whether the contracts are priced in stablecoins. However, this should not be a major concern, as there is always arbitrage risk when using centralized exchanges.
Discounted Futures Sometimes Come With Surprises
As of September 9, ether (ETH) futures maturing on December 30 are trading at $22 or 1.3% below the current price on spot exchanges such as Coinbase and Kraken. The difference emerges from the expectation of merging forked coins generated during the Ethereum merge. Buyers of the derivatives contract will not be provided with any of the potential free coins that Ether holders receive.
Airdrops can also lead to discounted futures prices because holders of derivatives contracts will not receive rewards, but this is not the only case behind decoupling as each exchange has its own pricing mechanism and risk. For example, Polkadot quarterly futures on Binance and OKEx are trading at a discount versus DOT price on spot exchanges.
Note how the futures contract trades at a 1.5% to 4% discount between May and August. This lag reflects a lack of demand from leveraged buyers. However, given the long-term trend and the fact that Polkadot is up 40% from July 26 to August 12, external factors are likely at play.
Futures contracts are priced separately from spot exchanges, so traders should adjust their targets and entry levels when using quarterly markets.
Higher fees and value decoupling must be considered
The main advantage of futures contracts is leverage, or the ability to trade large amounts from the initial deposit (collateral or margin).
Let’s consider a scenario where an investor deposits $100 and buys $2,000 USD worth of bitcoin (BTC) futures using 20x leverage.
Even though trading fees on derivatives contracts are usually smaller than spot markers, a notional 0.05% fee applies to a trade of $2,000. Therefore, a one-time entry and exit of the position will cost $4, which is equivalent to 4% of the initial deposit. It may not sound like much, but increasing turnover does weigh such a toll.
Even though traders understand the additional costs and benefits of using a futures instrument, an unknown element presents itself only in volatile market conditions. A decoupling between the derivatives contract and regular spot exchanges usually results in liquidation.
When a trader’s collateral becomes insufficient to cover the risk, the derivatives exchange has a built-in mechanism that closes the position. This liquidation mechanism can cause heavy price action and result in the index detracting from the price.
While these distortions would not lead to further liquidations, uninformed investors could react to price fluctuations that only occurred in derivatives contracts. To be clear, derivatives exchanges rely on external pricing sources, usually from regular spot markets, to calculate the reference index price.
There is nothing wrong with these unique processes, but all traders should consider their implications before using leverage. Price decoupling, high fees and liquidation effects must be analyzed when trading the futures markets.
The views and opinions expressed here are those of Author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should do your own research when making a decision.
