What is an Inverse Futures Contract?

An inverse futures contract is a type of financial agreement in which the seller must pay the buyer the difference between the agreed-upon price and the current price at the contract's expiration. Unlike traditional futures, the seller profits when prices decline.

These contracts are valued in fiat currencies like the US dollar or stablecoins such as Tether (USDT), regardless of the cryptocurrency being traded. There's an inverse relationship between profit and loss (PnL) and the price movements of the underlying cryptocurrency.

Inverse futures contracts are a type of derivative, priced in USD, but settled and margined using the underlying cryptocurrency. For instance, the BTC/USD pair's market price is in USD, but profit and margin are calculated in Bitcoin (BTC).

How Does an Inverse Futures Contract Work?

Inverse futures contracts operate non-linearly. When a trader goes long on a BTC/USD inverse futures contract, they are effectively shorting the USD. The trader's position is worth less in Bitcoin as Bitcoin's value rises, increasing in value relative to the dollar.

To illustrate, let's consider a BTC position using inverse futures contracts:

• Position size: 1 BTC

• Entry price (BTC): $62,000

• Exit price (BTC): $69,000

To calculate profit:

Profit Calculation Formula

Using the entry and exit prices, the profit (or loss) is determined in terms of the base crypto.

For a 1-BTC position in an inverse BTC/USD futures contract with an entry price of $62,000 and an exit price of $69,000, the profit calculation would yield 0.00000164 BTC. This profit appears in the trader's crypto wallet. Traders who expect asset values to increase take "long" positions, betting on price rises. In inverse contracts, investors with long positions gain from the underlying asset's appreciation against USD, in this case, BTC.

Suppose an investor takes a long position in inverse contracts linked to BTC/USD. As Bitcoin's price increases, so does the value of their Bitcoin holdings. Consequently, their USD-denominated holdings also increase in value, allowing them to profit from favorable market conditions.

Difference Between Linear and Inverse Futures Contracts

Linear futures contracts are settled in stablecoins (e.g., USDT), while inverse futures contracts are settled in the underlying cryptocurrency (e.g., BTC).

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

In contrast, 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 and Inverse Futures Contracts

• Linear Contract (BTC_USDT): Settled in stablecoins like USDT, allowing flexibility and simplifying trading operations by eliminating the need to buy the underlying cryptocurrency.

• Inverse Contract (BTC_USDT): Settled in the underlying cryptocurrency, making it straightforward to calculate profits in fiat currency when settlements are in stablecoins like USDT. This ease facilitates better financial planning and analysis for traders.

Advantages of Inverse Futures Contracts

Inverse futures contracts offer several benefits to traders, including long-term stack-building, leverage in bullish markets, and effective hedging without converting holdings to stablecoins like USDT.

Advantages:

1. Long-Term Stack-Building: Profits from inverse futures contracts, priced and settled in crypto, can be reinvested directly into long-term cryptocurrency holdings, helping miners and long-term holders build their crypto stack over time.

2. Leverage in Bull Markets: During bull markets, inverse futures contracts provide leverage, enabling traders to increase their profits when the value of the underlying cryptocurrency rises. This leverage can amplify profits for traders who correctly predict price increases.

3. Hedging: Traders can hedge their positions without converting holdings into stablecoins by maintaining investments in crypto assets. This strategy enhances risk management in futures trading by protecting against potential losses while keeping exposure to the cryptocurrency market.

Risks Associated with Inverse Futures Contracts

Traders should be aware of several risks when dealing with inverse futures contracts, including market volatility, counterparty risks, and liquidity concerns.

Risks:

1. Market Volatility: Inverse futures contracts can be highly susceptible to market fluctuations, which can amplify both profits and losses. Rapid changes in the underlying cryptocurrency’s price can lead to significant losses for traders.

2. Counterparty Risks: Trading platforms or exchanges facilitate inverse futures contract trading. If an exchange defaults or goes bankrupt, traders may lose their funds due to counterparty risk.

3. Liquidity Risk: Liquidity issues can arise, especially during market stress or low trading activity. Lower liquidity can lead to higher slippage, affecting profitability and making it difficult for traders to execute trades at desired prices.