Before proceeding, it would be best if you read these two articles to get a better understanding of inverse futures contracts:
- What are futures contracts?
- What is inverse Bitcoin futures contract?
- Understanding okex futures basic mechanics
Trading on the spot means trading a non-derivative pair like BTC/USD on a regular exchange (Bitstamp, Coinbase, et cetera). You exchange your dollars or euros or another fiat for bitcoins directly, and it gets credited to your account immediately once the trade is executed, no need to wait for the settlement date like with a futures contracts.
There are some differences between trading on the spot and trading an inverse futures contracts, to better understand it let’s take a look at the following examples (we will neglect the fees and use of leverage for the simplicity of understanding the concept).
Long spot and long futures
Suppose you buy one BTC at the price of $7,500, and the price goes to $10,000, and you sell. You gained $2,500 profit ($2,500 worth of BTC at $10,000 is 0.25 BTC).
Now let’s do the same at okex.com futures market (well almost the same, as it’s not a spot exchange). You have one BTC at your account, and you go long 75 contracts at $7,500 (one contract is $100), and since you went long on BTC, you’re, essentially, went short on USD/BTC pair (inverted BTC/USD). Your entry price in BTC on this USD short will be 0.01333 (one contract is 1/75 of BTC at $7,500, hence it’s worth 1/75 = 0.01333 BTC). The price of BTC goes to $10,000, and now one $100 contract in terms of BTC is worth $100/$10,000 or 0.01, and you exit your position. Your gain here will be 0.01333 – 0.01 = ~0.00333 on each contract. Holding 75 contracts makes your total gain ~0.24975 BTC (0.00333*75 = ~0.24975) or ~$2,500 at the price of BTC at $10,000 (almost exactly 0.25 BTC, 1/75 gives you infinite 0.013333…, so there’s a little error).
Here comes the trick. It seems like you gained the same amount in both cases, about 0.25 BTC, but remember, the one bitcoin you used to go long 75 contracts at $7,500 is now worth $10,000. So in total, your gain in USD would be $5,000 ($2,500 from 0.25 BTC gained trading and $2,500 from one bitcoin you held at your account to buy 75 contracts).
If the price moved against you on okex.com, your losses in fiat would be higher too, since the bitcoins you used to open contracts are now worth fewer dollars, and you’re also losing BTC directly on your contracts because the market is going against you.
Short spot and short futures
Now let’s conduct the same experiment but with shorting and compare it to shorting the regular spot market (we will not talk about funding and trading fees to simplify the example).
You sell one BTC short at $10,000, and the price goes to $7,500, you repurchase it and realise a profit of $2,500, nice and neat.
You sell short 100 okex futures contracts at $10,000 which costs you precisely one BTC at the price of $10,000. Again, think of it as if you went long on USD vs BTC, and if the price of BTC drops, your USD is now worth more in terms of BTC, and that’s how you profit. Your entry price in BTC would be 0.01 (one $100 contract is worth 1/100 of $10,000). Bitcoin price drops to $7,500, and one contract is now worth 0.01333 BTC ($100/$7,500 = 0.01333), this is your exit price. Your gain on this USD long (aka “BTC short”) is 0.01333-0.01 = ~0.00333 BTC on one contract and ~0.333 on 100 contracts. At the price of $7,500, your 0,333 BTC worth almost exactly $2,500. So, you gained 0.333 BTC but your one bitcoin which was used to open 100 short contracts now worth $7,500, so you lost $2,500 on it. In total your BTC gain on this trade will offset your loss on holding one bitcoin, and your total worth at the end will be same $10,000, but now you have ~1.3333 BTC instead of one.
If the price moved against your short position to $12,500, one contract would be worth 0.008 BTC ($100/$12,500 = 0.008), so you would lose 0.01 (entry) – 0.008 (exit) = 0.002 BTC on each contract, or 0.2 BTC on 100 contracts in total. This leaves 0.8 BTC which is worth $10,000 at $12,500 per BTC. Your USD net worth is staying the same, but you lose 0.2 BTC.
Four possible outcomes in inverse futures
- you’re long, and the price moves in your favour: you gain BTC as well as USD value since BTC held by you rising in value also;
- you’re long, and the price moves against you: you lose BTC, and the USD value of bitcoins also drops;
- you’re short, and the price moves in your favour: you gain BTC, but the value of bitcoins depreciates in USD;
- you’re short, and the price moves against you: you lose BTC, but you’re USD losses are offset by rising value of BTC;
Linear USD value payouts
It is crucial to understand that USD profit or loss with inverse futures contracts is linear, but the payout in BTC is non-linear. Below you can see the profit/loss curves for the examples provided above (click to enlarge). Notice how shorting inverse non-linear futures contract locks in the USD value of your bitcoins. In other words, if you’re short inverse futures contract, the USD value of your position will stay the same no matter where the price will go (fees neglected).
Being long in inverse futures provide you with double gains and double losses in USD value since the collateral you used to open the position is losing or gaining value as well. In the spot market, the USD used as collateral (quote currency), and it cannot lose or gain value versus itself.
The inverse futures market and the spot market are two very different instruments. Being long in inverse futures provides you with twice as significant USD losses or gains compared to the spot and holding a short position will lock in the value of in terms of USD, no matter where the price of BTC will go. Inverse futures are a perfect instrument for hedging fiat value of your cryptocurrency.