Inverse Futures Contract. When a seller enters into an inverse futures contract, they commit to paying the buyer the difference between the agreed-upon price and the current price when the contract expires. The seller stands to gain from falling prices, unlike with traditional futures.
An inverse futures contract’s value is pegged to a fiat currency like the USD or a stablecoin like Tether (USDT), regardless of the underlying cryptocurrency being traded. Profit and loss (PnL) is inversely related to the price movement of the underlying cryptocurrency. Inverse futures contracts are derivatives that use the underlying cryptocurrency for pricing and settlement/margining. For instance, while the profit and margin are computed in Bitcoin (BTC), the market price of the BTC/USD pair is determined in USD.
How Does an Inverse Futures Contract Work?
An inverse futures contract’s characteristics are non-linear. One way to short the US dollar is to go long on the Bitcoin/US dollar inverse futures contract. Since the contract is inverse, the trader’s position is denominated in Bitcoin but grows with respect to the dollar as Bitcoin’s value increases. Using an example will help you grasp the calculations involved with inverse futures contracts and how they work. Profit for a Bitcoin investment utilizing inverse futures contracts is what it entails. So, here’s how it works:
- Position size: 1 BTC
- Entry price (BTC): $62,000
- Exit price (BTC): $69,000
To calculate the profit, the formula used is:
Profit=Position Size * (1/Entry Price – 1/Exit Price)
This formula considers the difference between the entry and exit prices to calculate the gain (or loss) in terms of the base cryptocurrency.
We’ll pretend for a moment that the trader is using a 1-BTC position size in an inverse Bitcoin/USD futures contract. If the starting price was $62,000 and the selling price was $69,000, the formula would be: This transaction would have resulted in a profit of 0.00000164 BTC for the trader, as shown in their cryptocurrency wallet. Some people take “long” positions, which means they are wagering that asset prices will rise to make a profit. With inverse contracts, long-term investors can profit when the underlying asset (in this example, Bitcoin) rises relative to the US dollar.
Imagine for a moment that a trader decides to go long on inverse futures tied to the BTC/USD pair. When the price of Bitcoin goes up, their holdings are worth more. Consequently, their USD assets grow in value with the increase in Bitcoin’s price. Investors have a great chance to profit from favorable market conditions because the value of the inverse contracts denominated in US dollars is closely associated with the price of Bitcoin.
Difference Between Linear Futures Contract and Inverse Futures Contract
Inverse futures contracts settle in the underlying cryptocurrency (e.g., Bitcoin), but linear futures contracts use a stablecoin (e.g., USDT) as its settlement mechanism. The trader’s use and earnings of a single currency characterize a linear futures contract. For instance, the margin and profit/loss are expressed in USD in a Bitcoin contract with a USD price. A linear futures contract, sometimes called “vanilla,” uses the quotation currency to price the margin and profit/loss. Consequently, margining and settlement for a plain vanilla Bitcoin futures contract are done in USD.
In contrast, an inverse futures contract allows the trader to use the base currency (like Bitcoin) while earning or losing in the quote currency (like USD). One advantage of linear futures contracts is the freedom they give traders. Traders can settle in stablecoins like USDT across several futures marketplaces. Because of this, funding futures contracts no longer requires purchasing underlying cryptocurrency, which streamlines trading procedures.
When using stablecoins like USDT for settlements, it’s easy to figure out how much money you made in fiat currency. Traders can more easily assess their gains or losses in traditional money, allowing for better financial planning and analysis.
Advantages of Inverse Futures Contracts
You can construct long-term stacks with the aid of inverse futures contracts. These contracts let you reinvest gains into your cryptocurrency holdings, which increases your profits when markets are positive. Plus, they are good hedging tools that don’t convert your assets into stablecoins like USDT. Inverse futures contracts have the following benefits:
Long-term stack-building
With inverse futures contracts, traders may reinvest their profits directly into their cryptocurrency holdings for the long term. These contracts are priced and settled in crypto. As a result, it facilitates the gradual accumulation of cryptocurrency holdings by miners and long-term holders.
Leverage in bull markets
In a bull market, traders can maximize their profits when the value of the underlying cryptocurrency increases by using inverse futures contracts, which provide them leverage. This leverage could increase profits for traders who accurately forecast increases in price fluctuations.
Hedging
By simultaneously owning and investing in crypto assets, traders may protect their positions in the futures market without liquidating any of their holdings into stablecoins like USDT. Futures traders can better control risk by hedging against potential losses while maintaining exposure to the cryptocurrency market.
Risks of Inverse Futures Contracts
Crypto traders dealing with inverse futures contracts must consider liquidity concerns, counterparty risks, and market volatility.
Market volatility
Market volatility can magnify gains or losses for inverse futures contracts. Investors risk losing a lot of money if the price of the underlying cryptocurrency drops suddenly.
Counterparty risks
The trading of inverse futures contracts often occurs on trading platforms or exchanges. There is a counterparty default risk if the exchange can’t pay its bills or goes bankrupt, which might lead to traders losing their money.
Liquidity risk
Inverse futures contracts are susceptible to liquidity problems, which might manifest during market stress or low trading volume. Traders may find it difficult to complete trades at the prices they desire, and overall profitability may be affected by lower liquidity, which increases slippage.