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How Trading Futures Contracts Works

Future trading works via three separate components: units per contract, leverage options, and expiration dates. These three components support two different ways in which to settle futures contracts: physically delivered (buyer purchases and receives asset upon settlement of the contract) and cash-settled (transfer of cash between buyer and seller upon settlement)

Units per contract outline the exact metrics of the contract in terms of what one contract equates to for the asset. For example, a contract could be set up to mean one Bitcoin Futures Contract is equal to 10 bitcoins. So, the price of the contract is equal to the total price of the 10 bitcoins denominated in USD.

Leverage trading options is a methodology adopted by investors to increase potential gains on a futures contract. Leverage rates are determined by the platform itself (i.e., Binance, FTX). Leverage trading involves borrowing liquidity from an exchange to increase their purchasing power on an asset. 

Finally, the last component is that of an expiration date on the contract. Because investors are speculating on the future values of an asset, the expiration date sets the date when the futures contract must be settled by the two parties. This is when the buyer must purchase the futures contract from the seller at the agreed-upon price. Prior to the expiration date, buyers may sell the right to buy a futures contract to other investors.

The pricing of futures contracts is meant to track the price of the underlying asset. So, a Bitcoin futures contract would track the price of Bitcoin. This, however, is not always perfect and can lead to price discrepancies between futures contracts and the price of an asset during periods of higher volatility. This is called slippage and creates an opportunity for an entirely futures-based arbitrage market to exist. Arbitrage traders can trade futures contracts based on price discrepancies for a profit and drive up volume within the futures contract market.

Specific Use Cases

Investors can utilize futures contracts in specific circumstances. For this, Bitcoin serves as a good example. If an investor has reason to believe that Bitcoin will increase in value by a designated date, such as the end of the month, that investor could open a long position on Bitcoin by buying a futures contract with an expiration date of the end of the month.

There is also a specific concept called perpetual contracts, a type of futures contract. Perpetual contracts do not include an expiration date nor a specific settlement designation. In other words, these contracts can continue on forever until the two parties involved in the contract choose to close it. This is made possible by something called a funding rate in which both long and short positions make payments to one another depending on the price action of the underlying asset like Bitcoin.

Without an expiration date, perpetual contracts are a popular investment option among established cryptocurrency exchanges offering futures contracts such as BitMEX, Bybit, FTX, and Binance. With funding rates, the perpetual contracts are able to keep pricing close to the spot price of the asset and give traders additional financial tools with which to gain exposure to digital assets. For cryptocurrency exchanges, funding rates on perpetual contracts are usually paid out in crypto-native assets, most notably US Tether (USDT).

Key Concepts

Liquidity

Liquidity typically refers to the speed and efficiency in which assets can be exchanged between buyers and sellers within a secondary market. The more liquid a market is, the easier it is to buy or sell an asset like Bitcoin. Liquidity gives investors a number of insights into the health and wellness of financial markets, such as gauging overall risk, execution opportunities, or even assisting financial markets in price discovery - all of which factor into an investor's overall market strategy.

Exchanges selling assets with poor liquidity will lack sufficient numbers of buyers and sellers, making that exchange more subject to higher risks. This risk can materialize in different ways, such as leading to more price volatility (and a divergence between fair asset values and quoted exchange prices). 

Order Book Depth Summary 

For exchanges, a more specific metric pertaining to liquidity is that of order book depth. Order book depth refers to the cumulative number of outstanding bids within an order book from buyers and sellers wishing to exchange assets (in this case, futures contracts). These buyers and sellers exchange their assets for prices that range below and above the designated average asking price of the asset, giving an indication of price sentiment and overall existing liquidity of the asset being exchanged.

To gauge liquidity, a deeper book means there are more bids available and, subsequently, more buyers and sellers willing to exchange assets. This makes the asset more liquid on the exchange. Higher order book depth also means there is far less price slippage as individual trades have much less impact on the asset’s underlying price. Of course, the opposite is true for low depth order books. This means that there are less buyers and sellers creating bids, less liquidity, and more slippage resulting in greater price impacts.

Fees/Slippage

Exchanges function on the backs of fees - specified denominations charged for facilitating transactions on the platform. Crypto exchangers function similarly to traditional exchanges in this regard by introducing a small fee on top of transactions that buyers and sellers make when exchanging their assets. The fee implemented tends to vary on larger exchanges in a form of maker (providing liquidity) and taker (taking liquidity) model. This also is determined by other factors (depending on the exchange and its size in the market) like total transaction volume over a given period of time. For exchanges, there are generally incentives to attract and sustain liquidity on exchanges as it provides the most benefit to end users. So, this logically leads to higher fees for those removing liquidity than those providing liquidity to an exchange.

Price slippage, as mentioned previously, is the difference between the expected price of a trade and the price at which the trade is executed. When a trader places a market order on an exchange, they expect that order to be filled at the current price. However, this is not always the case, especially for large orders or illiquid markets. Slippage can occur for two reasons: A change in the bid/ask spread in between the time a trade is placed and the trade is filled, or insufficient market depth.

In times of high market volatility, the best bid and ask for a crypto asset can meaningfully change between the time the trade is placed and the time it’s executed. If the ultimate execution price is less than the expected execution price, the net result is positive slippage (advantageous result). Conversely, if the final execution price is greater than the expected execution price, the trader is subjected to negative slippage, a less favorable trade.

In less liquid markets, slippage can also result from insufficient market depth. For a CEX with a traditional order book,  depth is calculated from the number of bids and asks on either side of the mid price. The “deeper” the order book, the less sensitive the price to large whale orders. However, if the order book is “thin” (less liquidity), a large whale market order may move the price due to what is known as “order splitting.” When an order is too large to be filled at one price, it’s divided into multiple orders at different price levels. This is how slippage is realized.

Below is an example of the slippage experienced on the CEX Kraken when attempting to execute a $100,000 BTC and ETH order in 2020. Note that ETH slippage (green and yellow) is more volatile and higher on an absolute basis due to the inferior market depth of ETH vs BTC. While this example is dated, the relationship between slippage and illiquid altcoins remains valid.