Hedging on Mettalex: Comparison to Futures
Jun 17, 2021
Introduction to Hedging
Striving to educate less-experienced traders on the advantages of hedging, we launched a series of blog posts aimed at demonstrating how essential hedging is and what are the different financial instruments you can use to do it. In the first blog post of the series, we outlined what hedging is and why you should practice it, whereas the second one explored options contracts. Let’s now look into futures.
What are Futures Contracts?
Similar to options, a futures contract is a financial instrument that derives its price from an underlying asset’s future value. The futures contracts are also used for offsetting the risks associated with unpredictable price movements, inflation, raw materials shortages etc.
The futures contract is practically a legally binding agreement to sell or buy a standardized asset at a predetermined price and date.
Unlike options though, the buyer of a futures contract is obliged to acquire the underlying asset when the contract matures, while the seller needs to deliver.
Futures contracts are a commonly used instrument by all kinds of market participants such as commodity producers, manufacturers, traders, speculators, and hedgers.
A futures contract employs a standardized format and comprises several necessary elements:
- Underlying asset – the asset on whose value the futures contract is based may be a commodity, an agricultural product, equity etc.
- Quantity of the underlying asset – if the contract concerns crude oil, for instance, the quantity usually is 1000 barrels per 1 futures contract.
- Futures price – This represents the price at which the asset will be purchased or sold at the contract’s settlement date. The futures price is constantly fluctuating since it is determined by buyers and sellers i.e. practically – by supply and demand. The futures market operates as an auction where all bids and offers change all the time influenced by a number of factors, news, world events, etc.
- Delivery location – Although a contract is sometimes settled not with physical delivery, but in cash, the futures contract should specify where the asset will be delivered if required. A physical delivery may be linked to considerable transportation and storage costs.
- Delivery date i.e. the maturity date of the contract – This is the date when the buyer is required to purchase the underlying asset.
- The exchange where the trade is executed – Exchanges are the entities that create the futures contracts and, therefore, determine the specifications of each particular contract. They play an important role and are indispensable trading intermediaries. Let’s see why.
What is the role of the exchanges?
- First and foremost, the exchanges set the standards, to the extent that all futures contracts’ specifications are uniform except for the price.
- Exchanges are the ones that guarantee the settlement of contracts and for the delivery of the underlying asset when the contract expires.
- The exchanges set the official daily settlement price of open futures contracts. These prices are used to calculate profits and losses, as well as to identify whether any margin adjustments are necessary.
- Futures contracts are centrally cleared which means that every transaction has the exchange as the counterparty. Therefore, buyers and sellers do not trade with each other but with the exchange itself.
- Thus, exchanges eliminate the counterparty risks related to lack of liquidity.
In the futures markets, losers pay winners every day. This means no account losses are carried forward but must be cleared up every day. The dollar difference from the previous day’s settlement price to today’s settlement price determines the profit or loss.
Trading Strategies with Futures
Generally, traders enter a futures contract with the expectation that the underlying asset’s price will increase or fall. Taking a long position i.e. “buy” will be profitable if the asset’s spot price goes up. On the opposite side, going short meaning a “sell” will produce gains if the asset’s market price goes down.
For example, a construction company buys a steel futures contract to guarantee its raw materials supply, whereas a steel mill sells a steel contract to insure against potentially dropping prices of steel.
Though, not all market participants have a vested interest in the underlying asset and thus some won’t be holding the contract until expiration. Speculators generally exploit the price movements in order to record profits, without ever having to own / acquire the underlying asset. On the other hand, commodity producers and manufacturers may use futures mainly for their risk management potential and for the opportunity to acquire / sell the underlying asset at a predetermined price.
Apart from a long or a short position, some traders may consider a rolling futures strategy:
“Rolling futures contracts refers to extending the expiration or maturity of a position forward by closing the initial contract and opening a new longer-term contract for the same underlying asset at the then-current market price.”
That strategy’s success depends on whether the futures market is in contango – future prices are higher than current prices, fueled by inflation, insurance, storages, or in backwardation – future prices fall below current prices, triggered again by a shortage of the product.
Overall, all futures trading strategies require experience and deep knowledge of the product’s advantages and hidden risks, of market fluctuations, and of the nature and factors influencing the underlying asset.
Compared to options, futures are the preferred hedging instrument because, while you need to pay the premium to buy an options contract, it doesn’t cost anything to enter a futures one.
How Much Does Futures Trading Cost?
When entering a futures contract, no money is exchanged between the two parties. However, that does not mean that everybody is able to start trading futures. Market participants are required to abide by strict rules and margin requirements set by both exchanges and brokerage firms.
What does margin mean?
Investing in financial instruments on margin means that the investor borrows part of the purchase price from a broker. In such an agreement, the investor pays an interest on the amount they have borrowed and the purchased stock or securities act as a collateral.
Margin buying is a common practice since a larger initial capital may lead to larger profits. It creates financial leverage and the returns for the investor may be much higher if they invest borrowed capital. However, that practice also exposes them to much greater risk.
Here are some useful terms:
- A margin amount is the amount provided by the investor.
- The initial margin requirement is the minimum amount the investor must hold in their account when a purchase is made.
- The maintenance margin is the minimum amount the investor must hold in their margin account after a purchase has been made. It is usually set at 25% of the total value of the financial instruments in the margin account.
- Margin call – it occurs if the margin falls below the maintenance margin. It essentially requests the investor to top up their account. However, investors are often forced to liquidate open positions in order to satisfy that requirement.
Apart from these margin requirements, the exchanges may also ask for some deposits to make sure traders are trustworthy. As we discussed already, exchanges observe the price variations of the contract over time and calculate the product price threshold which is the maximum permitted daily price move per product. Taking into consideration the underlying asset’s price volatility and the value of that daily price change, the exchange sets a required margin.
If an investor’s daily loss results in their net holdings falling below established margin levels, they will be required to provide additional resources to replenish the amount back to required levels. Otherwise they again risk the liquidation of their positions.
In addition, margin requirements change over time, no matter if it is a long or a short position.
Types of Futures Contracts Available in the Crypto Space
Just like traditional futures contracts, crypto futures are used for risk management, hedging against unforeseen volatility, or simply for speculation. The main trading platforms that offer crypto futures are FTX, Binance Futures and Kraken Futures. Contracts there may be based on different crypto assets such as Bitcoin, Ether, Litecoin, Bitcoin Cash, and Ripple, and may be settled either in crypto or in fiat currencies. The more traditional Chicago Mercantile Exchange (CME) also offers Bitcoin and Ether futures.
The demand for crypto futures is increasing, because they offer several advantages to cryptocurrency spot trading:
- A trader can speculate on the underlying asset’s price movements and profit from its volatility without ever having to acquire the asset itself. Even short-term price moves can be exploited regardless whether the price goes up or down. For comparison, if a crypto asset is bought on the spot market, profit will be recorded only if its price goes up.
- Leverage makes crypto futures capital efficient – a trader can enter a futures contract for a fraction of the underlying asset’s price. For instance, a $5,000 investment may bring much higher yields if put into a BTC futures position than if invested in BTC itself.
- Currently, the BTC futures market is much more liquid, reaching a monthly turnover of $2 trillion, compared to the BTC spot market.
The aggregated dollar value of open interest in BTC futures positions jumped to $13 billion in mid-June – a signal that the market is stabilizing after the correction it suffered in May.
However, trading crypto futures is subject to the same, or in some cases even more significant, margin requirements as with traditional futures contracts. The larger a trader’s open positions, the more liquidity is required to credit potential risks. Moreover, the more volatile a currency pair, the higher margin is claimed.
Sudden price moves combined with not sufficient margins may often lead to liquidation of the open position and all the maintenance margin available in the trader’s account. This is what we witnessed in mid-May 2021 when the drop in the price of BTC resulted in more than $8 billion in BTC derivatives position liquidations due to margin calls.
Mettalex’s Position Tokens Compared to Futures Contracts
A number of similarities may be found comparing traditional futures contracts and Mettalex’s position tokens. The most obvious one is that both allow for taking a long or a short position on an underlying asset, be it a cryptocurrency, a traditional commodity, a spread, or an index token. Also, like futures exchanges, the Autonomous Market Maker (AMM) allows for any trade to be performed at any time – it will always assume the opposite position of any trade, thus eliminating counterparty risks.
However, the differences are even more and definitely work to Mettalex’s advantage. Here is why:
- The exposure to price movements is capped thanks to the price band within which all trades are done.
- There are no margin calls on Mettalex. The margin requirements for trading on Mettalex are fixed.
- The risk is 100% quantified. Users know exactly how much they can lose or earn even before opening a position.
- Mettalex’s position tokens do not expire. Open positions get settled only if the price band is breached or if the trader sells them back to the AMM.
- Settlement of positions on Mettalex is done only in stablecoins. Since there is no physical delivery of assets, no transportation or storage costs are required.
- The Mettalex team has no access to user funds. Every position on the DEX is fully collateralized in stablecoins stored in non-custodial smart contracts.
- The Mettalex UI is much easier to use than any other derivatives platform in the DeFi space.
- Mettalex is available everywhere in the world and currently, users can only be identified by their Ethereum or Binance Smart Chain wallets.*
- No single company provides liquidity on Mettalex, it is peer-generated.
- There is no daily settlement of gains and losses.
- Mettalex combines the best of both worlds – cryptocurrencies and commodity derivatives.
- Similar to crypto futures, but unlike the traditional commodity ones, Mettalex is available at all times, every single day, 24/7.
Mettalex offers an extremely easy-to-use and accessible alternative to the traditional derivatives trading experience. The costs and barriers to entry for inexperienced traders are significantly lower. But more importantly, the users do not need to worry about performing active maintenance in order to avoid margin calls or having to liquidate open positions to satisfy margin requirements.
All you need to do is go to dex.mettalex.com, choose your preferred market, and swap your BUSD or USDT for a short or a long position. Happy trading!
*Excluding users from the U.S.