4.2.0. Key Differences Between Spot and Futures Trading
The differences between crypto spot trading and futures trading are as follows:
1. Ownership
Unlike in spot trading, when you purchase a futures contract, you do not own the underlying cryptocurrency. Instead, you own a contract with an agreement to buy or sell a specific cryptocurrency at a future date.
2. Leverage
In spot trading, you only use your money (crypto or fiat) to transact. However, futures trading offers leverage. For example, to buy one Bitcoin in a spot market, you will need about 50 000 dollars. In futures trading, you can use just 1 000 dollars to place a trade for one Bitcoin. This is possible because of leveraging.
3. Flexibility
When you purchase Bitcoin in a spot market, you make a profit only if the price of Bitcoin goes up. If the price goes down, as in the bear market, you cannot make any profit, rather you can lose your money.
However, in futures trading, you can profit from short-term price movements regardless of direction. For instance, in futures markets, even when the price of Bitcoin falls, you can participate in the downward move and trade along with the momentum.
Therefore, with futures contracts, traders can develop sophisticated trading strategies such as short-selling, arbitrage, pairs trading, etc.
Additionally, futures contracts are also used to hedge against downside risk and protect a portfolio from extreme price volatility. Miners and long-term hodlers often use futures contracts to protect their portfolios from unexpected risks.
4. Liquidity
The futures markets offer deep liquidity with trillions in monthly volume. For example, the Bitcoin futures market sees an average monthly turnover of about 1.5 trillion dollars as at the writing of this manuscript, far greater than the Bitcoin spot markets’ trading volumes.
The robust liquidity of futures market supports the process of price discovery and allows traders to transact in the market swiftly and efficiently. A liquid market is generally associated with less risk because there is always someone willing to take the other side of a given position, and traders will incur less slippage.
Generally, crypto futures contracts offer protection against volatility and adverse price movements on their underlying asset. Also, it is a proxy tool for traders to speculate on the future prices of a specific cryptocurrency.
With futures contracts, you can take advantage of price volatility. Regardless of whether prices rise or fall, futures contracts enable you to participate in a cryptocurrency’s movements with ease. In other words, you can speculate on a cryptocurrency’s price rather than buying the underlying asset itself.
5. Price
The price of a cryptocurrency on the spot market is the ruling price for all spot transactions, and this is known as the spot price. Buyers and sellers determine crypto spot prices through an economic process of supply and demand.
In contrast, the futures price is based on its prevailing spot price plus the cost of carry during the interim before delivery. The basis represents the cost (value) of carry of a futures contract. Thus, the futures price is derivative, that is, derived from the value of the crypto. Therefore, the futures market is a form of a derivative market.
The basis, which is the cost of carry of a futures contract, can be a positive or negative number. A positive basis relationship means that the futures price trades higher than its spot price, and vice versa. The basis may fluctuate due to changes in supply and demand, but due to the forces of arbitrage, it will eventually go to zero on the expiration day.
6. Profitability
In summary, you can see that there are more profits to be made in futures trading than in spot trading, which is the traditional trading that many of us are aware of. However, your profitability in futures trading comes with a sacrifice – to study and know how it operates.
Important Requirement
Indeed, the complications behind dealing in crypto futures demand a significant commitment to learning the basics, including how they affect each trade.
Therefore, as you go through this module and subsequent ones, you may hear some new terminologies that appear confusing. If you are really interested in futures trading, you will need to do further study on this topic, especially on the practical sessions presented below.