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 amateur investors and analysts immediately conclude that it is the result of degenerate gamblers utilizing high leverage or other dangerous instruments. There is no doubt that some derivatives exchanges are notorious for pushing retail traders to utilize excessive leverage, but this does not represent the whole derivatives market.
Concerned investors, such as Nithin Kamath, founder and CEO of Zerodha, recently questioned how derivatives exchanges could withstand severe volatility while giving 100x leverage.
Huobi briefly reduced the maximum trading leverage for new customers to 5x on June 16, according to writer Colin Wu. By the end of the month, the exchange had barred users from China from trading derivatives on the site.
On July 19, Binance futures banned new users’ leverage trading to 20x due to regulatory pressure and likely community objections. Following the judgment a week later, FTX cited “efforts to encourage prudent trading.”
According to FTX creator Sam Bankman-Fried, the average open leverage position was approximately 2x, and only “a tiny fraction of activity on the platform” would be impacted. It’s unclear whether these actions were coordinated or even mandated by a regulatory body.
We recently demonstrated how a cryptocurrency’s usual 5% volatility leads 20x or higher leverage bets to be liquidated on a regular basis. As a result, the following three methods are frequently utilized by experienced traders, who are often more conservative and outspoken.
The majority of the coins used by margin traders are kept in hard wallets.
Most investors recognize the need of keeping as many coins as possible in a cold wallet since blocking tokens from being accessed via the internet reduces the danger of hacking significantly. The disadvantage, of course, is that this position may not arrive at the exchange on time, particularly when networks are busy.
As a result, futures contracts are the preferred tool among traders when they want to reduce their position in volatile markets. For example, by depositing a little margin, such as 5% of their assets, an investor can leverage it by ten times and significantly lower their net risk.
These traders could then sell their positions on spot markets as their transaction comes, closing the short position at the same time. Those who want to grow their exposure quickly with futures contracts should do the reverse. When the money (or stablecoins) arrive at the spot exchange, the derivatives position would be closed.
Cascade liquidations are being forced.
Whales understand that in volatile markets, liquidity tends to be restricted. As a result, some will open heavily leveraged positions with the expectation that they will be forced to close due to insufficient margins.
While they appear to be losing money on the trade, their true intention was to create cascade liquidations in order to move the market in their chosen direction. Of course, such a feat requires a big amount of capital and possibly many accounts.
Traders who use leverage profit from the ‘funding rate.’
Permanent contracts, sometimes known as inverse swaps, have an imbedded rate that is typically charged every eight hours. Funding rates ensure that no exchange risk imbalances exist. Despite the fact that both buyers’ and sellers’ open interest is always matched, the actual leverage employed can differ.
When buyers (longs) want higher leverage, the funding rate goes positive. As a result, the buyers will be responsible for paying the fees.
Market makers and arbitrage desks will constantly watch these rates and, eventually, build a leverage position in order to collect such fees. While this may appear to be a simple process, these traders will need to hedge their positions by purchasing (or selling) in the spot market.
To weather periods of volatility, using derivatives necessitates knowledge, experience, and, preferably, a big war chest. However, as demonstrated above, using leverage without becoming a risky trader is achievable.