July 28th, 2018
Guide for Beginners: What is Bitcoin Futures?
What are Futures Contracts?
Usually, when someone buys something, the transaction has an immediate settlement. For example, if you give someone 100 dollars for their Pokémon card collection and they agree, then the whole thing is done. Futures contracts work a bit different as its settlement is scheduled to occur at a specific date in the future, for an exact amount.
Futures are legal agreements in which assets can be bought or sold at a fixed amount for a specific price, at an established time in the future.
A futures contract consists of two elements: the price, and the date of settlement.
Once the terms for the futures contract has set, all involved parties have to transact at the established price, regardless of what the actual market price might be at the time when the contract has to be executed.
The idea here is not to make the most profit, but to manage risk. This strategy is often used in financial markets to hedge against the risk of the price volatility of the items which are traded regularly.
Because of this, futures are also used in portfolios to even out price swings on investments, where the primary asset has a volatile nature.
The negotiation and trading for these contracts take place on futures exchange which serves as the intermediary.
How do futures contracts work?
Just like with margin trading, there are also two positions from which a futures contract can be traded: long or short.
With a long position, the buyer agrees to purchase the asset in the future at a set price when the contract reaches its expiration date. If the buyer takes a short position, then they agree to sell an asset at a specific price at expiration date.
The seller takes the long position to get a higher price on Bitcoin when the contract expires, while the buyer aims for an overall favorable price.
The advantage here is that both parties are protecting themselves against the volatility of the contract’s underlying asset, which is in our case Bitcoin.
There are also investors who speculate with futures contracts rather than using it as a protection mechanism.
They will intentionally go long when Bitcoin is experiencing price dips. As prices go higher, the contract becomes increases in value, and the investor can opt to trade the contract before it expires, at an increased price.
What are Bitcoin futures?
With Bitcoin futures, investors can speculate and make trades on the price of Bitcoin without them actually having to own any Bitcoins themselves.
Futures can be traded on financial assets as well as on normal exchanges.
With Bitcoin futures, investors can base the contract on the price of Bitcoin and they place a “bet” on what they think Bitcoin’s price will be in the future. Bitcoin futures work exactly on the same principles as futures that have traditional financial assets in their contracts.
This leads to two major consequences for the traders. Seeing as Bitcoin doesn’t have a clear and homogeneous regulation, futures enable Bitcoin to be traded on regulated exchanges. This is an advantage for investors, as they do not have to worry about the risks that may arise from the lack of regulation in Bitcoin trading.
When trading BTC on crypto exchanges, these service providers have to conform to the laws which are instated by the country in which the country operates. This may lead to many issues and inconveniences, especially if the trader is from another country that has another set of legislative rules in place or if the exchange he is using is unregulated.
Also, in regions where trading Bitcoin is banned, Bitcoin futures offer investors a loophole through which they can still make speculations on the coin’s price.
Trading Bitcoin futures
Momentarily, trading with Bitcoin futures is still mostly unregulated. But this situation is expected to be changed in the future, as more brokers are expected to adopt Bitcoin futures.
Only a handful of cryptocurrency exchanges currently offer Bitcoin futures trading, such as OKCoin and BitMEX. BTC futures are also offered by regulated exchanges such as The Chicago Mercantile Exchange (CME), the top exchange in the traditional fiat economy, and The Chicago Board Options Exchange (CBOE), the biggest exchange in the US.
The Chicago Mercantile Exchange’s Bitcoin futures trading involves first finding a broker which trades on CME which will agree to make the bet on your behalf. For their service, a fee will also be needed. Then your broker will proceed to open a margin account together with you.
How Is the Price Established?
There are three key factors that decide the price of Bitcoin futures:
- the expiration code (the expiration date)
- the bid (the buying price)
- the ask (the selling price)
The entities that interact with these prices will be known as individual speculator, a market maker, or an arbitrageur.
The market maker is either a business or an institution will act as both the buyer and the seller for the asset traded. This means that said firm assures its clients that it will keep the bid/ask prices at a relatively close margin.
A minimum tic size of $25 is required for each contract, which means that the price cannot vary in raises smaller than 25 dollars per contract (5 dollars per Bitcoin).
There is a daily price fluctuation cap of 20% above or below the settlement price of the day before. This is done to keep runaway flash crashes limited, this phenomenon is of common occurrence on current cryptocurrency exchanges.
Also, CME only allows a contract size to be of maximum 5 bitcoins, so for example, at its current price of $ 8,289 USD, each contract is worth $ 41,445 USD.
Considering there is a 35% percent margin required, a balance of $14,500 has to be maintained just to keep one futures contract.
While at the moment Bitcoin futures are not largely at use, in the future it might interest more investors as it constitutes a financial tool for mitigating risk. And seeing as Bitcoin may seem a discouraging asset for investment, these contracts may be able to give them the confidence to start trading in the crypto world.