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Why Do Spot And Futures Prices Differ?

With the crypto market trending downwards since last December, many traders have been unable to profit via conventional buy low, sell high strategies. Some have given up, while others have entered the contracts battlefield. Novices to the futures market would first and foremost notice asset prices differences between spot and futures. Why is this so?

Futures and spot are different trading types which exist in various markets and user groups.

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The spot price is the current market price of a digital asset that is available to be bought/sold for immediate settlement. Simply put, it is the price at which the traders value an asset right now.

In contrast to spot assets, futures contracts are basically financial contracts between two parties to sell and buy assets at a set price in the future. The duration of future contracts may vary, but the settlement dates of each contract are always fixed, meaning the two parties must agree on a predefined settlement date before they enter into a futures contract.

In short, the main difference between spot prices and futures prices is that spot prices are for immediate buying and selling, while futures contracts delay payment and delivery to predetermined future dates. This natural difference in properties between the two are also the cause of their price differences.

What is important to note is that the price difference will always remain within a reasonable range. Let’s take a look at delivery futures at digital asset exchanges, which are largely similar to the traditional futures market.

A quick search on Huobi Global will reveal various expiration periods for an asset, including Weekly, Bi-weekly and Quarterly contracts. Let’s take BTC/USDT Bi-weekly 0916 as an example.

🔹Example

BTC/USDT Bi-weekly 0916 is a delivery contract that will expire on Sep 30.

Suppose that on Sep 8, Sarah bought 2 BTC on Huobi at a price of 19,200 USDT and was worried that the price would soon drop; she then immediately opened a 2 BTC short position on the above-mentioned BTC/USDT Bi-weekly 0916 contract at the market price of 19184.40USDT.

If the BTC spot price does fall to 18,185 USDT at the time of delivery on Sep 16, and the contract settlement price is 18184.40 USDT , Sarah’s profits from contract trading would be (19184.40USDT-18184.30 USDT)*2=2,000 USDT, which would make up for her loss of close to the same amount from spot trading over the same period.

This example is an illustration of the important role futures contracts play in hedging. If the spot price was exactly the same as the contract price, this functionality would not exist.

In fact, when the delivery date approaches, the price of a futures contract will tend to converge with its corresponding spot price. After the 0916 Bi-weekly contract is delivered, in fact, when the delivery date approaches, the price of a futures contract will tend to converge with its corresponding spot price. After the 0916 Bi-weekly contract is delivered, the system will generate a new bi-weekly contract in accordance with market needs.

In 2016, a crypto exchange introduced a new futures contract termed Perpetual Swaps. Unlike a typical futures contract, perpetual swaps do not have expiration dates. So how does a perpetual contract ensure a reasonable spread with an asset’s spot price?

In the case of a futures contract’s delivery, it would be unnecessary to maintain a price peg since the price of the contract and the underlying asset will automatically converge as the expiration date nears. However, the absence of expiration dates in perpetual swaps means exchanges have to implement a price anchoring mechanism, known as the “funding rate.” By either incentivizing or disincentivizing the longs or shorts, this mechanism balances the short and long positions of perpetual swaps.

In addition to the funding rate mechanism to help anchor the spot price, the arbitrage actions by retail investors or institutional investors also keeps the price difference between the two at a reasonable level.

🔹To begin trading on Huobi Global, click here.

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