Back to basics
Futures trading is arguably the most exciting way to invest in digital assets.
If you’re new to this, or want to gain insight into how we’ve organized futures trading at AAX, this guide hopes to provide the answers.
To simplify things, we’ll take BTC/USD as our basic trading pair, and for now, we’ll leave exchange fees out of the picture.
Spot trading vs futures trading
First, we must outline the fundamental differences between spot and futures trading.
Spot trading is pretty straightforward. Let’s say you have $10,000 and you trade into Bitcoin at a market price of $10,000 (= 1 BTC).
If the price goes up by 10%, and you decide to exit the market, you’ll have made 10% profit. If it goes down by 10%, and you sell, you’ll have lost 10%.
With futures trading, you don’t actually buy into Bitcoin. Rather, you take a view on the future price of Bitcoin, and trade into contracts that derive their value from Bitcoin.
Instead of ‘buying’ and ‘selling’, with contracts we say you can ‘go long’ or ‘short’. If you expect the price to go up, you go long; if you expect it to go down, you go short.
If you go long and the price goes up, you can make a profit. Likewise, if you go short and the price goes down, you can make a profit.
At AAX, we are offering the opportunity for investors to leverage their position when they buy futures contracts. This means that although you may only be able or willing to deposit a small margin, with leverage you can significantly increase exposure.
The maximum you can leverage is up to 100 times your original position.
Let’s say, for the sake of clarity, $1 gets you 1 Bitcoin futures contract, and you only want to put in $1,000.
With a 100x leverage, $1,000 gets you 100,000 contracts, worth $100,000.
If you go long, meaning you expect the price to go up, and you decide to close your position once the price has risen by 5%, you’ll have made a $5,000 profit. If you exit at 10%, your profit would be $10,000.
If you expect the price to go down, go short, and exit the market once the price has fallen by 10%, you’ll also have made a $10,000 profit.
But what happens if things don’t go as you expected?
Here it’s crucial to know that when it comes to losses, you can never lose more than what you’ve put in, which in the above scenario is $1000.
If you go long with $1,000, at 100x leverage, but the price goes down, you will automatically exit the market right before you make your $1,000 loss.
Likewise, if you go short, but the price unexpectedly goes up, your position will automatically be liquidated right before you hit the $1,000 point of loss.
Whatever your margin is, whether it $10, $100, or more, the amount you put in as your margin is always equal to your maximum loss. We refer to this as the default position.
The trade-off is as follows: the higher the leverage, the bigger your potential profits, but the less room you have for the price to go in the undesired direction.
If you trade into contracts with only 2x leverage, you’ll have much more room to cope with price volatility, with a decreased chance of being forced out of your position.
In part, how much you leverage depends on how certain you are about the price direction and how much price volatility you expect.
Use cases for futures trading
Because you can engage in futures trading with up to 100x leverage, you’re able to achieve much more with less.
You may have strong ideas about where the market is heading, and leverage enables you to enter the market with a big position using a small amount of capital.
If you have $100 at your disposal, leverage allows you to trade futures with a maximum of $10,000.
The contracts used in futures trading on AAX are so-called ‘perpetual contracts’, meaning that, unless you’re forced to liquidate due to having hit your point of maximum loss, you yourself are free to decide when you exit the market.
Compared to contracts with an expiry date, perpetual contracts are also convenient for traders as they won’t have to keep checking when their contracts are due to end.
Another reason why you may want to trade futures is that futures contracts can serve as a hedge against falling prices in spot markets you may be invested in.
For example, if you hold Bitcoin and the price of Bitcoin is on a downward trend, you may want to go short on Bitcoin futures to compensate for your losses on the spot market.
How much you should put into futures contracts or the exact leverage that’s appropriate to achieve the optimal balance will be dependent on your own expectations, calculations, and overall strategy.
As explained, when futures trading on AAX, Irrespective of leverage, you can never lose more than you’ve actually put in as your margin.
Once you hit your point of maximum loss - or your default position - AAX will help you exit the market. However, this ultimately always depends on liquidity, meaning for AAX to be able to liquidate your contracts, there must be a counterparty.
Similar to exiting the spot market, you cannot sell your assets, unless there is a buyer.
At AAX, we guarantee that you cannot lose more than your margin, and we do so by way of our Default Fund.
Here’s how it works: if your margin is $100, AAX will aim to close your position right before you reach the point of losing your margin.
If we’re able to do so, for example, if your margin is $100 and we’re able to close your position at a loss of $99.5, then the difference - in this case, $0.50 - will be redirected to AAX’s Default Fund.
If due to lack of liquidity, automatic liquidation does not happen on time, meaning your position is closed below your point of default, you still won’t lose more than you’ve put in.
The outstanding difference is covered by the Default Fund.
At AAX, a level playing field is among our key principles. This is why we have a funding scheme, designed to facilitate fair arbitrage (between the spot and futures trading market).
Since the futures market is essentially a reflection of expectations that investors are taking on an asset’s price in the spot market, we can expect the futures price movements to generally - though not always - reflect movements in the spot price.
Since this is an imperfect process, we have a funding scheme - consisting of two mechanisms - in place to make up for the difference.
This facilitates true price discovery and helps track the spot market more closely.
AAX futures contracts auto-rollover every 8 hours with a funding rate mechanism paid between long and short positions. In order to maintain a balanced supply of long and short positions, a settlement also takes place to cover for interest differences.
It’s important to know that AAX settles both premium and interest payments directly between accounts, and does not charge any commissions in the process.
Practically, AAX - which maintains an index referencing multiple external spot markets - calculates the price difference between the futures and spot market, and automatically settles that difference between all futures market participants.
This process is very similar to the premium mechanism, except in this case AAX references the external market for interest rates.
It’s a small adjustment due to the interest rate difference between the base and quote currencies.
For the purpose of clarity, this beginner’s guide only deals with basic principles around futures trading.
For more information on exchange fees, or the exact formulas and calculations used to determine the exact liquidation price, premium and interest rates, please refer to our Advanced Futures Guide.
If you have any specific questions about how to trade futures, make sure to check our tutorial section on AAX Academy.