Most traders believe that futures contracts are exclusively used to place high-risk, high-leverage wagers, although the instruments have a wide range of applications.
When data on futures contract liquidation becomes available, many beginner investors and analysts automatically assume it’s due to degenerate gamblers utilizing high leverage or other dangerous instruments. While some derivatives exchanges are well-known for encouraging retail traders to utilize excessive leverage, this does not apply to the whole derivatives sector.
Concerned investors, such as Nithin Kamath, the founder and CEO of Zerodha, have recently questioned how derivatives exchanges could cope with severe volatility while offering 100x leverage.
In regulated space, even with all checks & balances, brokerage firms once in a while on days of extreme volatility go bust.— Nithin Kamath (@Nithin0dha) May 19, 2021
If exchange offers 50x leverage & say Bitcoin goes down 4% in one tick, a customer with $1K, can lose $2K. Additional $1K to be put up by the platform
Huobi briefly reduced the maximum trading leverage for new customers to 5x on June 16, according to writer Colin Wu. The exchange has barred Chinese users from trading futures on the site by the end of the month.
On July 19, Binance futures limited new customers’ leverage trading to 20x under regulatory pressure and likely community objections. FTX followed suit a week later, citing “efforts to encourage responsible trading.”
The average open leverage position on the platform, according to FTX creator Sam Bankman-Fried, is around 2x, and only “a tiny fraction of activity on the platform” will be impacted. It’s unclear if these actions were coordinated or even mandated by a regulatory body.
Cointelegraph previously showed how a cryptocurrencies’ typical 5% volatility causes 20x or higher leverage positions to be liquidated regularly. Thus, here are three strategies often used by professional traders are often more conservative and assertive.
Margin traders keep most of their coins on hard wallets
Most investors understand the importance of keeping as much of their coins in a cold wallet as feasible because blocking internet access to tokens greatly reduces the danger of hacking. Of course, the disadvantage is that this position may not arrive at the exchange in time, particularly if networks are busy.
As a result, when traders wish to reduce their position in volatile markets, futures contracts are the preferable vehicle. An investor can leverage their holdings by 10x by depositing a tiny margin, such as 5% of their holdings, and dramatically lower their net exposure.
These traders could then sell their positions on spot exchanges as their transaction is completed, closing the short position at the same time. Those hoping to enhance their exposure with futures contracts should do the exact opposite. When the money (or stablecoins) arrives at the spot exchange, the derivatives position will be closed.
Forcing cascading liquidations
Whales know that during volatile markets, the liquidity tends to be reduced. As a result, some will intentionally open highly leveraged positions, expecting them to be forcefully terminated due to insufficient margins.
While they are ‘apparently’ losing money on the trade, they actually intended to force cascading liquidations to pressure the market in their preferred direction. Of course, a trader needs a large amount of capital and potentially multiple accounts to execute such a feat.
Leverage traders profit from the ‘funding rate’
Perpetual contracts, also known as inverse swaps, have an embedded rate usually charged every eight hours. Funding rates ensure that there are no exchange risk imbalances. Even though both buyers’ and sellers’ open interest is matched at all times, the actual leverage used can vary.
When buyers (longs) are the ones demanding more leverage, the funding rate goes positive. Therefore, those buyers will be the ones paying up the fees.
Market makers and arbitrage desks will constantly monitor these rates and eventually open a leverage position to collect such fees. While it sounds easy to execute, these traders will need to hedge their positions by buying (or selling) in the spot market.
Using derivatives requires knowledge, experience, and preferably a sizable war chest to withstand periods of volatility. However, as shown above, it is possible to use leverage without being a reckless trader.