Inverse futures contract, explained

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-upon price and the current price upon contract expiration. In contrast to conventional futures, the seller benefits from price declines.

How does an inverse futures contract work?

The nature of an inverse futures contract is non-linear. When a trader goes long on the BTC/USD inverse futures contract, they are shorting the USD. As the contract is inverse, the trader’s position is worth less in Bitcoin, and the higher the value of Bitcoin, the more it increases in relation to the dollar.

To understand how inverse futures contracts operate and the related calculations, let’s use an example. It involves the calculation of profit for a position in BTC using inverse futures contracts. 

Here’s a breakdown:

• Position size: 1 BTC 
• Entry price (BTC): $62,000
• Exit price (BTC): $69,000

To calculate the profit, the formula used is:

This formula uses the difference between the entry and exit prices to determine the profit (or loss) in terms of the base crypto.

Let’s assume that the user is trading an inverse BTC/USD futures contract with a 1-BTC position size. The calculation would be as follows if the entry price was $62,000 and the exit price was $69,000:

Suppose an investor chooses to take a position long in inverse contracts linked to BTC/USD. The value of their Bitcoin holdings rises in tandem with the price of the cryptocurrency. As a result, their USD holdings increase in value in line with the rise in the price of Bitcoin. The price of Bitcoin and the value of the inverse contracts denominated in U.S. dollars are directly correlated, providing investors with an easy opportunity to profit from favorable market conditions.

The difference between linear futures contract and inverse futures contract

Linear futures contracts are settled in a stablecoin (like USDT), while inverse futures contracts are settled in the underlying cryptocurrency (like BTC).

In a linear futures contract, the trader uses and earns the same currency. For example, in a Bitcoin contract priced in USD, both the margin and profit/loss are in USD. The margin and profit/loss are priced in the quotation currency in a linear futures contract, often called “vanilla.” Therefore, a vanilla futures contract on Bitcoin priced in USD is margined and settled in USD.

Conversely, in an inverse futures contract, the trader uses the base currency — e.g., Bitcoin — but earns profit/loss in the quote currency — e.g., USD. 

Comparison of linear futures contract and inverse futures contract:

It is simple to calculate profits in fiat currency when settlements are made in stablecoins like USDT. Better financial planning and analysis are made possible for traders by the ease with which they may evaluate their gains or losses in terms of traditional currency.

Advantages of inverse futures contracts

Inverse futures contracts help traders build long-term stacks by allowing them to reinvest earnings into cryptocurrency holdings, provide leverage in bullish markets for higher profits, and function as effective hedging instruments without converting holdings into stablecoins like USDT.

Here are the advantages of inverse futures contracts:

Long-term stack-building

Trader profits can be reinvested directly into long-term cryptocurrency holdings through inverse futures contracts, which are priced and settled in crypto. It helps miners and long-term holders build their crypto stack steadily over time.

Leverage in bull markets

Hedging

Traders can hedge their positions in the futures market without changing any of their holdings into stablecoins like USDT by holding and investing in crypto assets at the same time. This improves risk management skills in futures trading by enabling traders to protect against possible losses while keeping exposure to the cryptocurrency market.

Risks associated with inverse futures contracts

Crypto traders dealing with inverse futures contracts must consider liquidity concerns, counterparty risks and market volatility.

Market volatility

Inverse futures contracts may be extremely susceptible to fluctuations in the market, boosting profits as well as losses. Quick changes in the underlying cryptocurrency’s price can cause traders to suffer large losses.

Counterparty risks

Trading platforms or exchanges are usually involved in inverse futures contract trading. If the exchange is unable to pay its dues or becomes bankrupt, there is a chance of a counterparty default, which might result in traders losing their money.

Liquidity risk

Liquidity issues may arise with inverse futures contracts, particularly in 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 prices they want.