3 Ways Futures Traders Can Use Leverage and Avoid Liquidation Losses

Every now and then, headlines will appear about $100 million or more worth of Bitcoin (BTC) and cryptocurrency futures contracts being liquidated, with novice traders and non-expert analysts pointing the finger at excessive leverage by retail traders as the cause.

Gamblers are undoubtedly responsible for a significant portion of risky gambling, especially when liquidations are concentrated on retail-focused exchanges like Bybit and Binance. However, not all futures liquidations are due to reckless use of leverage.

Not all futures liquidations are due to leverage.

Some trading strategies used by professionals may be liquidated when there is a sudden price spike, but this does not necessarily indicate a loss or excessive leverage. Chicago Mercantile Exchange (CME), OKX, and Deribit generally have much lower liquidation rates compared to retail-focused exchanges, indicating that these traders are usually using more advanced strategies.

It is quite easy to use the futures market, especially the perpetual contracts (reverse swaps). Almost all cryptocurrency exchanges offer leverage of 20x or more, and only require an initial deposit, known as margin.

However, unlike regular spot trading, futures contracts cannot be withdrawn from the exchange. These leveraged futures contracts are synthetic, but they also offer the possibility of shorting, allowing you to bet on a price decline.

These derivatives have their own advantages and can improve a trader’s results, but overconfident traders rarely make profits in the medium to long term. To avoid falling into this mental trap, professional traders usually use three different strategies that aim to maximize profits, rather than relying solely on directional trading.

Forced liquidation for pairs with low liquidity

Whales use futures contracts to target illiquid pairs and take advantage of volatile markets. They open positions with high leverage, expecting to be forced to liquidate due to lack of margin. This triggers a chain reaction that pushes the market in their favor.

For example, if a price drop is needed, a large number of positions are sold, causing other traders to liquidate and sell, causing the price to fall even further. This may seem like a loss at first, but the chain effect helps the strategy.

Implementing this strategy requires significant capital and multiple accounts. It effectively leverages market mechanisms to have a significant impact, and understanding market behavior is crucial to this approach.

Cash and Carry Transactions

Cash and carry trade involves buying an asset in the spot market and simultaneously selling a futures contract for the same asset. This strategy locks in the price difference between the spot price and the futures price. The trader holds the asset until the futures contract expires, profiting from the convergence of these prices at expiration.

This arbitrage approach is low risk and exploits price inefficiencies between markets. It is particularly effective in stable markets and provides consistent returns regardless of overall market volatility, making it a preferred strategy for risk-averse investors.

Funding rate arbitrage

Perpetual contracts (reverse swaps) typically charge a funding rate to balance buyers and sellers every 8 hours. This rate varies depending on market leverage demand. If buyers (longs) demand more leverage, the funding rate will be positive and buyers will pay a fee.

Market makers and arbitrage desks take advantage of these differences by opening leveraged positions and hedging by buying or selling on the spot market. We also explore the differences between exchange-traded or perpetual and monthly contracts.

This strategy, called funding rate arbitrage, requires constant monitoring and precise execution to maximize returns and effectively manage risk by leveraging different rates across the market.

In essence, using derivatives requires knowledge, experience, and significant capital reserves to withstand market volatility. However, strategies such as funding rate arbitrage can be effective even in less volatile markets where price movements are minimal. This approach demonstrates that leverage can be used prudently to maximize profits even in calm market conditions.