Many traders often express some pretty big misconceptions about cryptocurrency futures trading, especially on derivatives exchanges outside of traditional finance. The most common errors include futures market price unbundling, fees and the impact of liquidations on the derivative instrument.
Let’s explore three simple mistakes and misconceptions that traders should avoid when trading crypto futures.
Derivative contracts differ from spot trading in pricing and trading
Currently, the total open interest in crypto futures exceeds $25 billion, and retail traders and experienced fund managers use these instruments to leverage their crypto positions.
Futures contracts and other derivatives are often used to reduce risk or increase exposure and are not actually intended to be used for degenerate gambling, despite this common interpretation.
Crypto derivative contracts usually lack some differentiation in pricing and trading. For this reason, traders should at least consider these differences when venturing into the futures markets. Even experienced traditional asset derivative investors are prone to error, so it’s important to understand the specifics before using leverage.
Most cryptocurrency trading services do not use US dollars, even if they display quotes in USD. This is a big untold secret and one of the pitfalls that derivatives traders face, which causes additional risks and distortions in futures trading and analysis.
A pressing issue is the lack of transparency, so clients don’t actually know if contracts are valued in stablecoins. However, this should not be a major concern as there is always intermediary risk when using centralized exchanges.
Discounted futures sometimes bring surprises
September 9 Ether (ETH) futures that mature on December 30 are trading at $22, or 1.3% below the current price, on spot exchanges like Coinbase and Kraken. The difference is due to the expectation of merging fork coins that could arise during the Ethereum merger. Buyers of derivative contracts will not be awarded any of the potentially free coins Ether holders can obtain.
Airdrops can also cause discounted futures prices because holders of derivative contracts do not get the price, but this is not the only case of decoupling, as each exchange has its own pricing mechanism and risks. For example, quarterly Polkadot futures on Binance and OKX traded at a discount to the price of DOT on spot exchanges.
Note how the futures trade traded at a 1.5% to 4% discount between May and August. This lag shows insufficient demand from leveraged buyers. However, considering the long-term trend and the fact that Polkadot rose 40% from July 26 to August 12, external factors are likely at play.
The price of the futures contract has decoupled from the spot exchanges, so traders must adjust their targets and entry levels whenever they use the quarterly markets.
Higher fees and price separation should be considered
The main advantage of futures contracts is leverage, or the ability to trade amounts that are higher than the initial deposit (guarantee or margin).
Consider a scenario where an investor deposits $100 and buys (long) $2,000 worth of bitcoins (BTC) futures using 20x leverage.
While trading fees for derivative contracts are typically lower than spot markers, a hypothetical 0.05% fee applies to a $2,000 trade. Therefore, a one-time entry and exit from a position will cost $4, which is equivalent to 4% of the initial deposit. This may not sound like much, but such a tax weighs with increasing turnover.
While traders understand the additional costs and benefits of using a futures instrument, the unknown element tends to only occur during volatile market conditions. The separation between a derivative contract and regular spot exchanges is usually caused by liquidations.
When the trader’s collateral becomes insufficient to cover the risk, the derivatives exchange has a built-in mechanism to close out the position. This liquidation mechanism can cause drastic price action and subsequent decoupling from the price of the index.
Although these disruptions do not trigger further liquidations, uninformed investors may react to price fluctuations that occurred only in the derivative contract. To be clear, derivatives exchanges rely on external sources of prices, usually from regular spot markets, to calculate the reference index price.
There is nothing wrong with these unique processes, but all traders should consider their impact before using leverage. When trading in the futures markets, price separation, higher fees and the impact of liquidation should be analyzed.
The views and opinions expressed here are solely the opinions author and do not necessarily reflect the views of Cointelegraph. Every investment and trading step involves risk. You should do your own research when deciding.