Home » Theory » Why shorting inverse futures is perfect for hedging

Inverse futures, first devised just several years ago, quickly became the most dominant cryptocurrency trading derivative. Bitmex.com perpetual inverse contract records billions of USD in daily volumes. These contracts have some unique properties which are essential to understand. One of the features of inverse contracts is the ability to “lock in” the USD value or your bitcoins with a short position, essentially, removing the exposure to the BTC/USD pair movements.

The next list of articles is suggested to read first if you’re hearing about inverse futures for the first time:

Hedging in conventional markets

In traditional markets to hedge your exposure to price movements of the asset, you would need to open a second position which will offset the possible losses or gains. For instance, if you have a natural long position on gold, you can open a short position in a futures market for the same notional amount as your gold holdings. Then, if the price of gold declines, a profit from the futures position will offset the loss. However, if the price goes up, the futures loss will negate the gain.

Both positions have to be of the same value, and the price of a futures contract has to correlate nicely with the spot price to make such hedge as useful as possible. The net result of these two positions is the removal of the exposure to the price movements of gold. In reality, though, it is a bit more tricky, and the futures hedging is always a subject to the basis risk.

Why short position in inverse futures has constant USD value?

One of the most critical properties of the inverse contracts is that a short position opened without leverage, theoretically, can never get liquidated and is always worth the same amount of USD if we’re talking about the BTC/USD pair for example (we neglect any possible fees to simplify the explanation).

To understand why it is so, you need to realise that the BTC/USD inverse contract is nothing else but a linear futures for USD/BTC pair but with the price quoted not as USD/BTC (bitcoins per one dollar), but as more common BTC/USD (dollars per bitcoin).

If the pair were quoted as USD/BTC and not as BTC/USD, it would be highly confusing. Traders would have to go short when they want to long bitcoin, and long when they want to short it.

That is why the profit loss formula for inverse futures has one divided by BTC/USD price in it. It tells us how much one dollar is worth in bitcoins (USD/BTC price) so that we can calculate the profit loss denominated in bitcoins.

+/-(1/Entry_Price - 1/Exit_Price)*number_of_contracts
+ for long
- for short

When you open a short position in inverse futures quoted as BTC/USD, under the hood you go long on USD/BTC. In other words, you agree to buy a specific amount of USD priced in BTC in the future for whatever the price may be. That is the critical point, and that is precisely why your short position is always worth the same amount of USD. The bitcoin price may go up or down, but as long as your position stays open, you are still in agreement to accept the delivery of an exact amount of USD priced in BTC. It can be worth more or less BTC in the future, but the amount of USD stays constant.

Why can you not get liquidated?

The other property of inverse futures is that when opening a short position with 100% margin (x1 leverage), theoretically, you cannot get liquidated, no matter where the price will go.

Remind yourself, that when you are long in linear futures with 100% margin, the maximum loss you can suffer is when the price goes to zero. If that happens, you lose all the margin you posted for this position. This rule applies to all long positions with 100% margin.

Well, the same happens when you are long USD/BTC pair, which is the same as being short inverse futures BTC/USD. If bitcoin price goes higher and higher in perpetuity, your USD position will be progressively worth less and less in terms of bitcoins. When you lose all your margin, it means that the USD/BTC pair went to zero, and the dollar is worth nothing in terms of BTC now. At that point, even your paper bills in your pocket wouldn’t buy you any bitcoins.

Example

Let’s now consider the following example to solidify our understanding of shorting inverse futures (fees and other costs neglected).

Futures price: 5,000 BTC/USD
Contract size: 1 USD
Direction: SHORT
Position size: 10,000 contracts
Margin: 2 BTC (100% required, no leverage)
Short P/L: -(1/entry - 1/exit)*number_of_contracts

In bitcoins, each dollar is worth 1/5,000 = 0.0002 BTC, so 10,000 contracts are worth 10,000*0.0002 BTC = 2 BTC. This amount is your full margin required to open a short position for ten thousand contracts at 5,000 BTC/USD.

Next, the price goes to $7,500 and your P/L is -0.66666666 BTC [-(1/5,000 – 1/7,500)*10,000]. We deduct this amount from the initial margin posted and end up with 1.33333333 BTC [2 – 0.66666666]. At the current price of 7,500 BTC/USD, this amount is equal to exactly $10,000 [1.33333333 * 7,500].

Now, the price goes in the direction of the short to $2,500, and P/L is equal to +2.00 BTC [-(1/5,000 – 1/2,500)*10,000]. We add this amount to the initial margin of 2.00 BTC and get 4.00 BTC in total. At the current price of 2,500 BTC/USD, four bitcoins are worth exactly $10,000 [4.00 * 2,500].

You can see that in both cases, our position is worth $10,000 no matter what (note that we didn’t apply any fees imposed by exchanges to these calculations to make it more simple).

While BTC P/L is non linear, the USD stays constant

Conclusion

The short position in inverse futures always represents the same amount of USD, since it’s, essentially, an agreement to deliver a certain amount of USD priced in bitcoins in the future. Once you’re short, the price can go up or down, but the USD value of your position stays constant. Such property makes these contracts perfect for hedging, as you only need one position to “lock in” the value. In contrast, you would need two positions open to hedge your exposure in traditional markets with direct/linear futures.

Leave a Comment

avatar
2500
Close Menu