Every once in a while, headlines about $100 million or larger Bitcoin (BTC) and crypto futures contracts liquidations appear, causing novice investors and non-expert analysts to point to excessive leverage by retail traders as the culprit.
Gamblers are undoubtedly responsible for a large portion of these risky bets, especially when the liquidation is concentrated on retail-oriented exchanges such as Bybit and Binance, but not every futures liquidation is the result of reckless leverage use.
Not all futures liquidation are caused by means leverage
Some trading strategies used by professionals also end up being liquidated during sudden sharp price moves, but they do not necessarily represent a loss, or a sign of excessive leverage. The Chicago Mercantile Exchange (CME), OKX and Deribit typically exhibit a much lower liquidation ratio when compared to retail-driven exchanges, indicating that those traders are usually deploying more advanced strategies.
Using futures markets, especially the perpetual contracts (inverse swaps) is fairly easy. Almost every crypto exchange offers 20x or higher leverage, requiring just an initial deposit, known as margin.
However, unlike regular spot trading, a futures contract cannot be withdrawn from the exchange. These leveraged futures contracts are synthetic, but they also offer the possibility to short, meaning one can bet on the price downside.
These derivatives instruments have unique benefits and can improve a trader's outcomes, but traders who become overly confident seldom end up being profitable in the mid to long term. To avoid falling into this mental trap, pro traders usually deploy three different strategies aiming to maximize profits without relying solely on directional trades.
Forced liquidations on low-liquidity pairs
Whales use futures contracts to exploit volatile markets by targeting low-liquidity pairs. They open highly leveraged positions, anticipating forced liquidations due to insufficient margins. This triggers a chain reaction, pushing the market in a preferred direction.
For instance, if a price drop is desired, large amounts are sold, causing other traders to get liquidated and sell as well, further driving down the price. Though it seems money is being lost initially, the cascading effect benefits the strategy.
Executing this tactic requires substantial capital and multiple accounts. It effectively leverages market mechanics to create a significant impact. Understanding market behavior is crucial for this approach.
Cash and carry trading
The cash and carry trade involves purchasing an asset in the spot market and simultaneously selling a futures contract on that same asset. This strategy locks in the price difference between the spot and futures prices. Traders hold the asset until the futures contract expires, profiting from the convergence of these prices at maturity.
This arbitrage approach is low-risk and capitalizes on pricing inefficiencies between the markets. It is particularly effective in stable markets, providing consistent returns irrespective of overall market volatility, making it a favored strategy among risk-averse investors.
Funding rate arbitrage
Perpetual contracts (inverse swaps) charge a funding rate typically every eight hours to balance buyers and sellers. This rate varies with market leverage demand. When buyers (longs) demand more leverage, the funding rate becomes positive, making buyers pay fees.
Market makers and arbitrage desks exploit these differences by opening leveraged positions and hedging them by buying or selling in the spot market. They also explore differences between exchanges or between perpetual and monthly contracts.
This strategy, called funding rate arbitrage, involves capitalizing on varying rates across markets, requiring constant monitoring and precise execution to maximize profits while managing risk effectively.
In essence, using derivatives requires knowledge, experience and a substantial capital reserve to withstand market volatility. However, strategies like funding rate arbitrage can be effective even in less volatile markets, where there is minimal price action. These approaches prove that it is possible to use leverage prudently, maximizing profits even in calmer market conditions.