Author: Dilip Kumar Patairya; Translated by: Wuzhu, Golden Finance
1. What is an inverse futures contract?
An inverse futures contract is a financial arrangement that requires the seller to pay the buyer the difference between the agreed price and the current price when the contract expires. Unlike traditional futures, the seller benefits from a fall in price.
Regardless of the underlying cryptocurrency being traded, the contract value of an inverse futures contract is denominated in fiat currency (such as the U.S. dollar) or a stablecoin (such as Tether's USDT). There is an inverse relationship between the profit and loss (PnL) and the price movement of the underlying cryptocurrency.
As a derivative, inverse futures contracts are priced in USD and settled/margined using the underlying cryptocurrency. For example, the market price of the BTC/USD pair is determined in USD, while profits and margin are calculated in Bitcoin (BTC).
2. How do inverse futures contracts work?
The nature of inverse futures contracts is nonlinear. When a trader goes long on a BTC/USD inverse futures contract, they are short the U.S. dollar. Because the contracts are inverse, the trader's position is worth less in Bitcoin, and the higher the value of Bitcoin, the higher its value relative to the U.S. dollar.
To understand how inverse futures contracts work and the calculations involved, let’s take an example. It involves calculating the profit of a BTC position using an inverse futures contract.
Here is the breakdown:
Position size: 1 BTC
Entry price (BTC): $62,000
Exit price (BTC): $69,000
The formula for calculating profit is as follows:
This formula uses the difference between the entry price and the exit price to determine the profit (or loss) of the underlying cryptocurrency.
Assume that the user is trading an inverse BTC/USD futures contract with a position size of 1-BTC. If the entry price is $62,000 and the exit price is $69,000, the calculation is as follows:
According to calculations, the trader will make a profit of 0.00000164 BTC from this trade, which will appear in their crypto wallet. Those who want to profit from the rise in the value of an asset sometimes go long, meaning they bet on the price to rise. On the inverse side of the contract, investors who take a long position will benefit from the appreciation of the underlying asset against the dollar (in this case, BTC).
Let's say an investor chooses to go long an inverse contract pegged to BTC/USD. The value of the Bitcoin they hold rises in tandem with the price of the cryptocurrency. Therefore, the value of the USD they hold increases as the price of Bitcoin rises. The price of Bitcoin and the value of the inverse USD-denominated contract are directly correlated, providing investors with an easy opportunity to profit from favorable market conditions.
3. The difference between forward futures contracts and reverse futures contracts
Linear futures contracts are settled in stablecoins (such as USDT), while inverse futures contracts are settled in the underlying cryptocurrency (such as BTC).
In linear futures contracts, traders use and earn in the same currency. For example, in a Bitcoin contract denominated in USD, margin and P&L are denominated in USD. In linear futures contracts, margin and P&L are denominated in the quote currency, often referred to as “vanilla”. Therefore, a Bitcoin vanilla futures contract denominated in USD is denominated and settled in USD.
Conversely, in an inverse futures contract, traders use the base currency (e.g. Bitcoin) but make profits and losses in the quote currency (e.g. USD).
Comparison between linear and inverse futures contracts:
Linear futures contracts offer flexibility as they allow traders to settle in stablecoins (such as USDT) across multiple futures markets. This simplifies trading operations as there is no need to purchase the underlying cryptocurrency to fund the futures contract.
When using stablecoins such as USDT for settlement, calculating profits in fiat currency is simple. Traders can easily evaluate gains or losses in traditional currencies, allowing for better financial planning and analysis.
IV. Advantages of Inverse Futures Contracts
Inverse futures contracts help traders build long-term reserves by allowing them to reinvest proceeds in cryptocurrency holdings, provide leverage for higher profits in a bull market, and act as an effective hedging tool without having to convert holdings into stablecoins such as USDT.
The following are the advantages of inverse futures contracts:
Long-term accumulation
Traders’ profits can be reinvested directly into long-term cryptocurrency holdings through inverse futures contracts, which are priced and settled in cryptocurrencies. It can help miners and long-term holders steadily build their cryptocurrency reserves over time.
Leverage in a bull market
During bull markets, inverse futures contracts can provide traders with leverage, allowing them to increase profits if the value of the underlying cryptocurrency rises. This leverage can increase profits for traders who correctly predict upward price changes.
Hedging
Traders can hedge their positions in the futures market by holding and investing in crypto assets simultaneously without converting any holdings into stablecoins such as USDT. This improves risk management skills in futures trading, allowing traders to protect against possible losses while maintaining exposure to the cryptocurrency market.
V. Risks associated with inverse futures contracts
Cryptocurrency traders engaging in inverse futures contracts must consider liquidity issues, counterparty risk, and market volatility.
Market volatility
Inverse futures contracts can be extremely susceptible to market volatility, increasing profits and losses. Rapid changes in the price of the underlying cryptocurrency can cause traders to suffer large losses.
Counterparty Risk
Trading platforms or exchanges usually engage in inverse futures contract transactions. If the exchange is unable to pay its dues or goes bankrupt, there is a possibility of counterparty default, which could result in the trader losing money.
Liquidity Risk
Inverse futures contracts can experience liquidity issues, especially during times of market stress or low trading activity. Lower liquidity can lead to greater slippage, which can affect overall profitability and make it difficult for traders to complete trades at the price they want.
