An inverse futures contract is a financial arrangement that needs the seller to pay the buyer the difference existing between the agreed-upon price and the current price upon contract expiration. Contrary to the conventional futures, the seller benefits from price drops.
Irrespective of the underlying crypto being traded, the contract value of an inverse futures contract is denominated in a fiat currency like the United States dollar or a stablecoin such as Tether (USDT). On that note, there is an inverse relationship between profit and loss (PnL) and the continuous movement of the underlying crypto’s price.
A type of derivative, an inverse futures contract is valued in USD and settled/margined using the underlying crypto. For instance, the market price of the BTC/USD pair is published in USD, while the profit and margin are calculated in Bitcoin (BTC).
How Inverse Futures Contract Operates
The nature of an inverse futures contract is non-linear. Whenever a trader goes long on the BTC/USD inverse futures contract, they short the USD. Since the contract is inverse, the trader’s position is worth less in Bitcoin, and the higher the value of Bitcoin, the more it surges in line with the dollar.
Here is an example to help understand how inverse futures contracts work and what the related calculations entail. It consists of the profit calculation for a position in BTC using inverse futures contracts.
Here is a breakdown:
- Position size: 1 BTC
- Entry price (BTC): $62,000
- Exit price (BTC): $66,000
To calculate the profit accumulated, the formula used is:
Profit = position size X (entry price – exit price)
The formula uses the difference between the entry and exit prices to determine the profit (or loss) in terms of the base crypto.
Let us assume that the user had traded an inverse BTC/USD futures contract having a 1-BTC position size. This calculation would be as follows if the entry value was $62,000 and the exit price was $66,000:
Profit = 1 X (1/$62,000 – 1/$66,000)
= 0.00001613 – 0.00001515
= 0.00000098 BTC
Based on the calculation, this trader would have made 0.00000098 BTC in profit from the deal, which is sent to their crypto wallet. Those users who want to profit from increasing asset values at times take ‘long’ positions, which means they are betting on price surges. In matters of inverse contracts, the investors who take a long position stand to gain from the underlying asset’s appreciation against the USD, in this case, BTC.
If an investor decides to take a position long in inverse contracts connected to BTC/USD. The value of their Bitcoin holdings surges simultaneously with the crypto price. On that note, their USD holdings gain value concurrently with the Bitcoin price surge.
The price of Bitcoin and the value of these inverse contracts denominated in US dollars are directly correlated, offering investors an easy opportunity to benefit from favorable market conditions.
The Difference Between Linear Futures Contract And Inverse Futures Contract
Linear futures contracts are settled in a stablecoin (such as USDT), while inverse futures contracts are settled in the underlying crypto (like Bitcoin).
In the case of the linear futures contract, the trader utilizes and earns the same currency. For instance, in a Bitcoin contract valued in USD, the margin and profit/loss are in USD. The margin and profit/loss are valued in the quotation currency in a linear futures contract, mostly known as “vanilla.” Thus, a vanilla futures contract on Bitcoin valued in USD is margined and settled in US dollars.
On the other hand, in an inverse futures contract, the trader utilizes the base currency, for instance, Bitcoin – but earns profit/loss in the quote currency – USD.
Since they enable traders to settle in stablecoins, like USDT, across multiple futures markets, linear futures contracts offer flexibility. This helps simplify trading activities by eliminating the need to acquire the underlying crypto to fund futures contracts.
It is significantly simple to calculate profits in fiat currency when these settlements are made in stablecoins such as USDT. Better financial planning and analysis are made possible for traders by the ease with which they evaluate their profits or losses in terms of the involved traditional currency.
Benefits Of Inverse Futures Contracts
Inverse futures contracts enable traders to create long-term stacks by letting them reinvest earnings into crypto holdings, offer leverage in bullish markets for increased profits, and operate as effective hedging apparatus without changing holdings into stablecoins like Tether’s USDT.
Here are some of the notable benefits of inverse futures contracts:
Long-Term Stack-Building
Experts say that trader profits can be reinvested into long-term crypto holdings directly via inverse futures contracts, which are valued and settled in crypto. It enables the miners and long-term holders to build their crypto stack continuously over time.
Leverage In Bull Markets
During bull markets, inverse futures contracts can offer traders leverage, allowing them to increase their profits when the value of the underlying crypto surges. For the traders who properly forecast increasing price changes, the leverage might boost profits.
Hedging
Traders can hedge their positions in the futures market without having to change any of their holdings into stablecoins such as USDT by holding and investing in crypto assets concurrently. This enhances risk management skills in futures trading by allowing traders to protect against potential losses while maintaining a healthy exposure to the crypto sector.
Risks Linked To Inverse Futures Contracts
Crypto traders that deal with inverse futures contracts need to consider liquidity concerns, counterparty risks, and market volatility.
Market Volatility
Inverse futures contracts might be excessively susceptible to changes in the market, increasing profits and losses. Rapid changes in the underlying crypto’s price can cause traders to suffer huge losses.
Counterparty Risks
Trading platforms and exchanges are normally involved in inverse futures contract trading. If the exchange cannot pay its dues or sinks into bankruptcy, there is a possibility of a counterparty default, which may result in traders losing their money.
Liquidity Risk
Liquidity issues may appear with inverse futures contracts, specifically when there is market stress or low trading activity. Lower liquidity can result in increased slippage, which can impact general profitability and make it challenging for traders to complete trades at any prices they want.
