Once in a while, news stories emerge detailing significant Bitcoin (BTC) and cryptocurrency futures contracts liquidations of $100 million or more. This occurrence often leads inexperienced investors and amateur analysts to attribute the issue to the excessive leverage utilized by retail traders.
Aggregate liquidations in the crypto futures market over a 24-hour period, depicted in USD. Source: Coinglass
While it is true that a considerable portion of these high-risk wagers are the handiwork of gamblers, particularly on retail-focused platforms like Bybit and Binance, it is important to note that not all futures liquidations stem from irresponsible leverage practices.
Not all instances of futures liquidation are a direct result of leverage misuse
In fact, certain trading strategies employed by professionals can also result in liquidations during sudden and drastic price fluctuations. However, these situations do not necessarily translate to losses or point to excessive leverage. Notably, exchanges such as the Chicago Mercantile Exchange (CME), OKX, and Deribit tend to have lower liquidation rates compared to retail-driven platforms, indicating that these traders often employ more sophisticated techniques.
Engaging in futures trading, especially perpetual contracts (inverse swaps), is relatively straightforward. Most cryptocurrency exchanges offer leverage of 20x or higher, requiring only an initial margin deposit. Unlike spot trading, futures contracts cannot be withdrawn from the exchange. While these leveraged futures contracts are synthetic in nature, they also provide the opportunity to take short positions, allowing individuals to speculate on price decreases.
Despite the advantages and potential for enhanced trading outcomes that these derivative instruments offer, traders who become overly confident often struggle to sustain profitability over the medium to long term. To avoid falling into this psychological trap, professional traders typically utilize three distinct strategies aimed at maximizing profits without relying solely on directional trades.
Forced liquidations in low-liquidity pairs
Large investors utilize futures contracts to capitalize on volatile markets by targeting low-liquidity trading pairs. By establishing highly leveraged positions, they anticipate forced liquidations owing to insufficient margins. This triggers a domino effect, influencing the market to move in a desired direction.
For instance, in scenarios where a price decline is favored, significant sell-offs initiate liquidations among other traders, leading to further selling and subsequently driving the price down. Although it may seem like money is being lost initially, this cascading effect aligns with the intended trading strategy.
Successful execution of this tactic necessitates substantial capital and the use of multiple accounts. It effectively harnesses market dynamics to generate a significant impact. A thorough understanding of market behavior proves essential in employing this strategy.
Cash and carry trading
The cash and carry trading strategy involves purchasing an asset on the spot market and simultaneously selling a futures contract for the same asset. This tactic locks in the price differential between spot and futures prices. Traders hold onto the asset until the futures contract matures, profiting from the convergence of these prices at expiry.
Characterized by low risk, this arbitrage approach capitalizes on pricing inefficiencies between markets. It is particularly effective in stable market conditions, offering consistent returns independent of overall market volatility. As a result, it is a preferred choice among risk-averse investors.
Funding rate arbitrage
Perpetual contracts charge a funding rate approximately every eight hours to balance leverage demand between buyers and sellers. This rate fluctuates based on market conditions. When buyers seek increased leverage, the funding rate turns positive, resulting in fees for buyers.
Arbitrage desks and market makers capitalize on these discrepancies by entering leveraged positions and hedging them through transactions on spot markets. They exploit variations between exchanges or between perpetual and monthly contracts.
Known as funding rate arbitrage, this strategy leverages differing rates across markets, necessitating continuous monitoring and precise execution to optimize profits while effectively managing risk.
In summary, navigating the realm of derivatives demands knowledge, experience, and a substantial financial reserve to withstand market fluctuations. Nevertheless, strategies like funding rate arbitrage can yield positive results even in less volatile markets where price movements are minimal. These approaches demonstrate the possibility of using leverage prudently to maximize returns, even in tranquil market conditions.
This article serves as general information and should not be interpreted as legal or investment advice. The opinions expressed are solely those of the author and do not necessarily align with or reflect the views of Cointelegraph.
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