June 14, 2024

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Particularly on derivatives exchanges outside the real world of traditional finance, where the most frequent errors involve future market price decoupling as well as fees and the effect of liquidations on the derivatives instrument, many traders frequently express relatively significant misconceptions about trading cryptocurrency futures.

The following three common errors and misunderstandings should be avoided by traders while trading cryptocurrency futures:

Derivative contracts differ from spot trading

The total open interest for futures contracts in the cryptocurrency market (1) currently exceeds $25 billion, and retail traders use professional fund managers to leverage their crypto bets. Contrary to popular belief, futures contracts and other derivatives are frequently used to lower risks and increase exposure; they are not intended for pathological gambling.

Trading in futures markets requires traders to consider variances in pricing and trading that are sometimes overlooked in cryptocurrency derivatives contracts. Even experienced investors in traditional assets who use derivatives are prone to blunders since it’s critical to comprehend the intricacies of the market before speculating.

One of the traps that derivatives traders fall into as a result of added risks and distortions when trading and analyzing futures markets is that most cryptocurrency trading services do not use dollars, even though they display USD quotations (2). Since there is an intermediate risk when using centralized exchanges, the most serious issue is the lack of transparency in which the clients are unaware that the contracts are priced as a stablecoin.

Discounted surprise

At spot exchanges like Coinbase (3) and Kraken (4), ether futures that mature on December 30 are trading for $22, or 1.3% less than the current price. The difference results from the expectation of the merge fork coins that will emerge during the Ethereum Merge (5). The possible free coins that an Ethereum holder might receive will not be given to buyers of derivatives contracts.

Since the holder of these derivatives contracts won’t receive the award, and each exchange has its pricing mechanisms and risks, airdrops can also result in discounted futures prices. As an example, Polkadot’s (6) quarterly futures on Binance (6) and OKX (7) have been trading at a discount compared to the Polkadot DOT price on spot exchanges.

The futures contracts that trade between May and August at a 1.5% to 4% discount are especially notable, as this backwardation shows a lack of interest from average purchasers. However, outside factors affect both the long-lasting trend and Polkadot, which increased 40% between July and August. Trading must now alter goal entry levels while using quarterly marketplaces as the futures contract price has decoupled from spot exchanges.

Higher fees and decoupled pricing

Leverage, or the capacity to trade quantities greater than the initial deposit that serves as collateral or margin, is the main advantage of futures contracts. If an investor deposits $100 and purchases long positions in Bitcoin BTC (8) futures worth $2,000 using 20x leverage, the hypothetical 0.05% trading charge is applied to the $2,000 trade. Trading fees for derivatives contracts are often lower than those for spot market transactions.

A single entry and exit into the position will cost $4.00, which is 4% of the initial deposit. This fee may not seem like much, but it adds up as the turnover rises. Even while traders know the additional expenses and advantages of using futures instruments, an unknown element frequently surfaces in the erratic market conditions.

When a trader’s collateral is insufficient to cover the risks, the derivatives exchange then chooses a built-in mechanism that closes the position, which indicates the liquidation mechanism might cause drastic price action with a subsequent decoupling from the index price. However, the decoupling between derivatives contracts and the regular spot exchanges is typically caused by liquidations.

Derivatives exchanges rely on external pricing sources, typically from normal sports markets, to determine the reference index price, even if these distortions could not cause subsequent liquidations with ignorant investors to reach such price swings.

There is nothing wrong with these special procedures. Still, before utilizing leverage or price decoupling, traders must consider the implications of greater fees and liquidation costs when trading on futures markets.

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