Futures Trading 101: Will Shorting Bitcoin Put Downward Pressure on Its Spot Price?

2021/11/18 11:03:31

Futures trading is also known as contract trading. Unlike Spot trading, Futures do not buy or sell a specified token but a contract. Another big difference between the Futures trading and Spot trading is that Spot trading only supports one-way trading. Simply speaking, users can make profits only if the price rises. Contract trading supports two-way trading, which means if the price falls and you go short, you can also make a profit.

Therefore, Futures trading is favored by a growing number of investors. According to the latest data from Coingecko, the trading volume of the Futures market is 1.25x more than that of the Spot market. With the expansion of the Futures market, an increasing number of altcoin Futures become available, and the KCS perpetual contract will be launched on the KuCoin Futures in the future.

However, the rapid development of Futures caused anxiety. Will enabling a token to be shorted can put downward pressure on its Spot price? What impact will the prosperity of Futures bring to the Spot market? This blog will dive deeper into the details.

The Function of Futures

Before answering this question, let's take a look at the three main functions of Futures.

1. Hedging risks. The main purpose of Futures trading is to hedge against the risk of price changes. For example, if a trader in the Spot market considers selling their tokens while trying to avoid losses caused by future price drops, they can avoid the risk of price fluctuations by choosing to short the asset in the Futures market.

2. Arbitrage. The Futures market reflects the future price, so in the short term, its price may deviate from the Spot market price. Once the price difference between the two markets is too large, there will be arbitrage space.

3. Speculation. In the Futures market, if you are willing to bear the high risk of market price changes, you will get high returns.

The Prices of Spot & Futures

Actually, Spot and Futures markets are two separate markets. While the Spot market shows only one price - the last trading price, the Futures market has Spot Index, Mark Price, and the last trading price.

Spot Index Price is the index that keeps track of the Spot market price. In KuCoin Futures, we adopt the Spot price across mainstream exchanges to avoid the user’s contract being liquidated during extreme market volatility. Take USDT-Margined BTC perpetual contract as an example; KuCoin Futures keeps track of the Spot price of BTC-USDT in 6 exchanges, including Huobi, OKEx, Binance, KuCoin, Poloniex, and HitBTC, and weighted calculation based on the quarterly trading volume of each exchange.

Mark Price is used to set the liquidation price and unrealized PNL. In traditional markets, a position is usually marked to the last trading price (i.e., mark to market), on which unrealized PNL and liquidation triggering depend. However, unnecessary liquidation may occur if the market is being manipulated, is illiquid or the Mark Price swings significantly relative to its Index Price. KuCoin Futures utilizes a system called Fair Price Marking to avoid the situations above. This system sets the Mark Price of the contract to the Fair Price instead of the last trading price. For Perpetual Contracts, the Fair Price is equal to the underlying Index Price plus a decaying Funding basis rate.

We can tell that the price of the Futures market is composed of the Spot price. To some extent, the relationship between the Spot and the Futures market is just like ontology and the shadow. The Spot market is the body, and the contract market is the shadow. It is easier to influence the shadow through the movement of the body but is difficult if vice versa.

Does the prosperity of the Futures market affect the price change of the Spot market?

What we can tell from the past development of the Bitcoin Spot market and Futures market is that, the prosperity of the Future market did not hinder the price change of the Spot market. Take KuCoin Futures as an example; at the beginning of 2021, the total amount of open interest on KuCoin Futures was around $116 million, which has increased to $3.3 billion so far, an increase by 30x compared to the beginning of 2021.

In addition, the overall scale-up of the Futures market has not affected the uptrend of Bitcoin price from $28,000 to $60,000.

The phenomenon can also be applied to traditional finance, where the scale of the derivatives market is much larger than the Spot market, and the Futures volume is almost 7x larger than the Spot trading volume. For example, according to S&P 500 Index, the current expansion of the Futures market didn’t stop the bull market, which grew all the way up from 2,000 to the top of 4,000, an increase by more than 100%.

Conclusion

In summary, from the past movement of both the traditional and crypto markets, the Futures has added extra power to balance the Spot market and reduce the fluctuation of the Spot market price to a certain extent. However, the fundamental force to influence the Spot price is the balance between demand and supply. We see that with the approval of Bitcoin Futures ETF, Bitcoin price breaks ATH, which attracts the influx of old money and traffic into the crypto space. It also clearly shows the great potential to be anticipated for both the Futures and Spot market.

Notice: KuCoin does not provide financial advice. Please do your own risk assessment when deciding how to invest in cryptocurrency and blockchain technology.