Well, I am sure the thought might have crossed in your mind while buying the future of any cryptocurrency – why is the price of future higher than the normal market price? It is just not you but many traders get confused about why Futures price tends to be in premium to the spot price. Traders are aware that the premium will be higher when the market is bullish and vice versa.

The article will help you in calculating the fair value of these contracts. It will be of great help to you in your next trade. Let us start!

What is the Fair Price/ Mark Price?

The fair price or mark price is an estimate of a true value of a contract (fair price) in comparison to its actual trading price (last price). Futures contract is marked according to the Fair Price Marking Method. This price is used to find out unrealized PNL and liquidations. Realized PnL is calculated using actual trading prices and is not affected by the fair price.

What is realized and unrealized PnL?

PnL in futures contract calculation is an abbreviation for profit and loss. It can be either realized or unrealized. When the trader has an open position on a particular derivative, his/her profit is unrealized. It means that there is variation in the profit/loss as per the market movement. Once the trader chooses to close his/her positions, the unrealized PnL gets transform into realized PnL.

Since the realized PnL refers to the profit or loss arising from the closed position, it has nothing to do with the mark price. On the contrary, the unrealized PnL is constantly changing and is the prime factor for liquidations. Hence, the fair price is used to assure that the unrealized PnL calculation is accurate and just.

Why is Fair Mark Pricing Used?

• Avoid Liquidations

Fair Mark Pricing can be used to optimize the liquidations. Consider a trade between trader A and B. While carrying on the trade, trader A is quite distracted and executes an order to buy 1,000,000 BTCUSD contracts instead of 100,000. Before executing the order, the BTCUSD order book was:

Bid/ask on Espay Exchange is between $7310-$7312

Fair Mark Price – $7309.8

Last Traded Price – $7302.0

Liquidation Price for Trader B – $7350

Now due to this error, the last traded price appreciated to $7360 for fraction of time and then depreciated back to the original last price – $7302

In such a scenario, if the exchange has used the last traded price instead of fair price, traded B would have been liquidated. But since they use fair price, trader B is covered and is not liquidated.

• Avoid Price Manipulations

If the market is very liquid, then the last traded price can be used instead of mark price. However, when the market is not liquid and lacks depth, there are high chances of its manipulation.

How is Fair Price/ Mark Price Calculated?

At the time of the maturity of the contract, the price of the futures contract equals the price of the underlying index, i.e.

Futures_Price = Underlying_Index_Price

Before the maturity, the price of the futures contract moves as per the price of the underlying index. But there is a difference between both of them which is referred to as basis. i.e.

Basis = Futures_Price – Underlying_Index_Price

I am sure you might be wondering about the reason behind the difference between the two prices. Well, there are many reasons behind it say interest rate, etc. But in the case of cryptocurrencies, the price difference is mainly due to supply and demand. Say for example, in the recent COVID-19 scenario, the annualized basis of BTC March futures went from premium to 0.82% discount.

We all are aware of the fact that the underlying index is the foundation of the futures contract. So, there is no doubt in drawing the conclusion that

Futures_Fair_Price = Underlying_Index_Price + Fair_Basis

Since Underlying Index Price is constant and independent of the trading, to calculate the fair price of the future, we will have to calculate the fair basis. Allow me to introduce the concept of impact price which is necessary to calculate the fair basis.

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