A futures contract can be defined as a mutual agreement between two parties for the future purchase or sale of an asset at a predetermined price. These contracts find their usage in both traditional markets and cryptocurrency trading for the purpose of either speculating on price movements or hedging against risk. Futures contracts, unlike the actual asset purchase, permit the traders to merely guess the direction of the price movement, upward or downward, without the need to possess the underlying asset.
In the case of cryptocurrency, futures become common since they provide the opportunity of leverage, where the trader can have a larger position with a smaller capital. The profits from the market movement in the trader’s favor would be huge. However, the same holds true for losses, which can escalate quickly if the market turns contrary to the trader’s expectation.
Futures trades can be taken long or short. A long trade will be profitable if the underlying market price goes up while a short one will be also profitable if the market price decreases. Contracts might have predetermined expiration dates, or in the case of perpetual futures, there might be no expiry at all. Perpetual futures use funding rates as a mechanism to keep prices synchronized with the spot market.
Futures contracts are indispensable in the process of price formation and also provide liquidity. Such contracts are popular with both professional traders and institutions since they provide the aforementioned features, the use of derivatives for hedging, and the opportunity to gain exposure to the crypto markets without having to take physical possession of the coins.
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