Inverse futures contract meaning

An inverse futures contract is a type of financial agreement obligating the seller to pay the buyer the price difference between a pre-specified price of an asset and its current value, upon the contract’s expiration.

What Is an Inverse Futures Contract?

An inverse futures contract is a financial derivative in which the seller profits when the price of the underlying asset declines. At the same time, the buyer benefits when the base cryptocurrency’s value rises.

In contrast to its linear counterpart, which is valued in a stablecoin or a fiat currency and settled or margined in the quotation currency, an inverse contract quoted in fiat or USD equivalents is margined and settled using the base cryptocurrency. Therefore, while linear futures are exposed to the volatility of their fiat money or USD equivalent, inverse futures are more susceptible to the underlying asset’s price fluctuations. 

For example, if the value of the BTC/USD pair is calculated in USD, its profit/loss and margin will be determined in BTC in an inverse contract.

Put another way, the relationship between the underlying asset’s price change is inverse or non-linear to its profit and loss (PnL). This means that a trader profits from a positive price difference between the contract’s price and the underlying asset’s value at expiry and loses when the difference is negative. 

How Do Inverse Contracts Work?

Inverse futures technically operate in a non-linear manner. This means when you are going long on (buying) an inverse futures trading pair, such as BTC/USD, you’re going short on (selling) the USD. In other words, your trading position becomes worth less Bitcoin and more USD as Bitcoin’s value increases. 

To explain this, consider a long BTC/USD inverse futures position, where the position size is 1 BTC with an entry price of $60,000 and an exit price of $70,000. The trader’s profit or loss will be determined by the difference between the entry price and exit price in terms of the underlying cryptocurrency. 

Profit/Loss = Position size * (1/Entry Price – 1/Exit Price)

= 1 BTC * (1/60,000 – 1/70,000) BTC

=  0.0238095 BTC

Therefore, in this case, the trader would yield a profit of  0.0238095 BTC. 

While it allows traders to hedge against market risks by speculating crypto price movements, this type of contract is also susceptible to market volatility, leverage risks, forced liquidation, and counterparty risks.