The cryptocurrency market has gone a long distance since its inception in the late 2000s, opening the gateway for the rise emergence of the first crypto derivatives companies and starting a movement that is common among emerging markets.
Recently, the sharp drop in the price of Bitcoin has had a big impact on the crypto derivatives market. When the world’s most valuable crypto asset reached its all-time peak in early 2021, few people would think that Bitcoin futures would enter backwardation not long after.
In this article, you will discover what Bitcoin futures are and how backwardation influences the crypto market. You’ll also see if it’s a better idea to buy bitcoin for the long term or to open a long position on it.
Understanding Crypto Derivatives – An In-Depth Explanation
Derivatives are contracts that involve a buyer and seller. The two parties agree to trade a financial asset at a certain price at a future date for settlement of the contract.
There are several types of derivatives, such as futures contracts, swaps, and options. Futures are derivatives backed by some financial asset (e.g., US dollar, Bitcoin, Ethereum, gold, etc.).
Hence, the price of a future is based on some index of the asset’s price at a future date. Commonly, futures contracts are used for three types of operation in the financial market – hedging (protection), speculation, and arbitrage.
To illustrate this concept, let us say there are two individuals called Beth and Earl. Beth is a crypto trader and she believes that the BTC price will peak at $100,000 in 3 months. On the other hand, Earl is a Bitcoin pro-miner and wants to profit by selling a Bitcoin for $100,000.
The two decide to use a future agreement in which Beth agrees to pay $100,00 for the Bitcoin Earl will mine in 3 months, while Earl agrees in selling a Bitcoin to Beth for the same price in 3 months.
Bitcoin Futures’ Pricing
Usually, Bitcoin futures will always have their quote reflected through an index of the main Bitcoin brokers in the market. However, some extra factors are taken into account when calculating the futures quote.
In this specific situation, the calculation of futures contract pricing is based on a mathematical model that takes into account the contract expiration time and the free rate of return.
The expiration time is when the futures contracts expire and the asset needs to be delivered. Each contract has a specific expiry time. The farther from expiring, the higher the contract quote. The risk-free rate of return is the economy’s basic interest rate.
Contango vs Backwardation
Given these factors, one can imagine that futures contracts have a higher price than the asset in the spot market. When that happens, we say the market is in Contango. Anyone who buys futures must pay a premium for the difference between the futures price and the spot market price.
However, there are some situations where the price of futures contracts is below the spot market. If the price curve assumes this tendency, we say that the market is in backwardation. That is, futures are discounted from the spot market.
The trend is for futures contracts to converge to the price of the asset in the market as they are approaching maturity. Therefore, contango contracts tend to fall and backwardation contracts tend to rise.
Bitcoin Derivatives in the 2021’s Market Landscape
Although Bitcoin’s price shocked investors, dropping 20% to a 6-month low, expert data shows that derivatives played an insignificant role in the situation. Instead, the massive liquidation was largely attributed to the capitulation of Chinese miners after they were forced to abruptly end their operations.
Additionally, on June 21, an official from the People’s Bank of China affirmed that all banks and payment institutions “should not provide account opening or registration for activities related to [virtual currency].”
Typically, Bitcoin futures should trade at a yearly premium of 5% to 15% in healthy markets. At the worst moment, on June 22, this base reached a 2.5% low, which is considered bearish, but not enough to trigger any red flags.
As a result, buyers’ lack of interest in the latest contracts does not reflect the current market sentiment. If traders were effectively in bearish mode, both long-term futures contracts and perpetual contracts would be following this trend.
Bitcoin futures trading has recently gone through a period of backwardation, especially in contracts that expired around June 25, 2021. Accordingly, expert data does not show current signs of long position stress or a potential downside swing caused by crypto derivatives markets.
While many traders point to the pullback as a bearish signal, there is currently no sign of excessive leverage on short positions. However, although these indicators are not so negative, it is crucial to note that trading derivatives involve significant financial risks.
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