On futures and open interest

When analyzing bitcoin cycles, futures markets are of particular interest.

Futures provide an opportunity to bet both on an increase and a decrease in price without owning the asset itself. At the same time, most exchanges offer leverage up to x100 – a paradise for gamblers. It is the ability to place a bet without having the asset itself, and large leverage that led to the fact that the most bitcoin trade volume is made on futures, and the difference with spot volumes is usually several hundred %.

The total number of futures contracts open by all market participants is called open interest (OI).

In order for the BTC futures price to be as close as possible to the spot price, there is a funding mechanism.

Funding is a percentage of an open position that you pay (or receive) depending on how the futures price relates to the spot price. If the futures price is higher than the spot price, the funding is positive, longs pay shorts; if the futures price is lower than the spot price, the funding is negative and shorts pay longs. This mechanism should balance the market in a natural way – the higher the price divergence, the more expensive it becomes to hold a position in the direction of increasing divergence and more profitable in the direction of decreasing.

There are several reasons why the futures market is of particular interest to traders and investors.

1. Risk management. The higher the OI, the higher the expected volatility and the lower the risk for open positions should be. Volatility with a high OI is caused by liquidations – forced closing of futures positions when the price goes in the wrong direction. Thus, the initial small move can be greatly amplified by a chain of liquidations. Each strong (10% +) move is, among other things, the result of the liquidation of futures positions for hundreds of millions of $.

2. Determination of the end of a bull market. Historically, each growth cycle ended at OI at local maximum and strongly positive funding. Why is this happening? After a long period of growth, the funding mechanism ceases to cope with balancing the futures market – there are too many people willing to hold a long position and too few – short. Often during such periods, the price of futures differs from the spot price by 1% or more. The strongest market participants are forced to take the short side and crash the price,this is greatly enhanced by chain liquidations. At one time, one of the largest futures exchanges, Bitmex, openly stated that it was trading against its clients in order to balance the price.

3. Determination of the end of a bear market. Historically, each bear market ended at a OI at local lows and strongly negative funding. After chain liquidations from point 2 (often organized several times over weeks or months), when the number of players willing to take the short side recovers, a period of reaccumulation begins, followed by a transition to bull market.

Every trader / investor has two different options. The first one is HODL, the futures market can be ignored – over a run of 5-10 years BTC is likely to grow anyway. The second is more active position management with an investment / trading horizon of less than a year, in this case the futures market should be understood and used to determine entry and exit points.