The institutional money has arrived in the cryptocurrency markets. Futures contracts were approved to trade in December 2017 by the Cboe, and in January 2018 by the CME Group. The move into crypto by large financial players brings credibility to the virtual asset and another notch on the belt for Bitcoin in its quest to become recognized as a legitimate currency.
However, understanding the investment principles behind futures contracts can become incredibly baffling to an average retail trader or novice investor. Here is everything you need to know about Bitcoin futures and how they affect the Bitcoin price.
Understanding Bitcoin Futures Contracts
Trading transactions are settled immediately when the position is closed, and your account is credited, or debited with the proceeds or losses of the trade. Futures contracts operate differently; instead of an immediate settlement, parties agree to settle the trade at some point in the future for a specified price. Therefore; futures contracts are comprised of two components; the date of expiry or delivery, and the cost of the deal.
The Advantages of Trading Bitcoin Futures
Leverage enables traders to stake a significant position, with only a fraction of the capital required. Leveraged trading requires traders to maintain a specific percentage of the total contract value in their margin account. The CME Group set that Bitcoin futures rate at 35%. Even though the trader does not pay for the full contract, they can still profit from the price volatility of the total contract price.
Futures markets allow traders to buy or sell the market as they please. Selling or “Shorting” the market realizes profits from the fall in the price of an asset during the futures contract period. Shorting cryptocurrency on exchanges requires that the trader borrow the underlying currency first and then pay interest. This methodology is not the same with futures contracts, therefore; futures contracts dramatically curtail the market friction of shorting, preventing market crashes.
Who Trades Bitcoin Futures Contracts?
Traditionally, futures contracts are traded by consumers and producers of the commodity to establish a hedge against future price movements. In the case of Bitcoin, crypto miners can purchase futures contracts to lock in their input costs and secure their pricing in the future with a hedge against market volatility. Selling futures is a hedge against the price moving down and buying futures hedges against upward price momentum.
Day traders, hedge funds, and portfolio managers also trade futures in the hope of making a profit on their capital investment using leverage and price volatility. Futures contracts do not require the physical delivery of Bitcoin, as the majority of futures contracts eventually settle for cash.
Can Retail Traders Buy Bitcoin Futures Contracts?
Futures are not just for institutional investors alone; even retail traders can purchase them. However, the contract size offered by the CME Group is currently 5 BTC, so at today’s rate of $6,250, a full contract would require $31,250. This large capital requirement puts the cost of trading futures out of reach for most retail traders and unsophisticated investors.
Traders can use margin if they do not have the entire $31,250 available. The CME require a 35% margin, meaning that the trader will need to keep a minimum of $10,950 in their margin account to prevent liquidation. If at any time the margin account balance slips under this threshold, due to an adverse price movement, the trader will have to add more margin to remain solvent. If they do not have the cash available to purchase more margin, they risk losing all their capital and perhaps even having to pay more to settle the loss.
The astronomical costs of a contract, even when using leverage, and the substantial risks involved with margin and liquidation mean that the majority of retail investors are not able to play in this market due to the high costs. Trading futures is better suited to wealthy investors that have large amounts of capital to play with and can afford to sit tight during a substantial drawdown.
What is the Correlation Between the Price of Futures and the Price of Bitcoin?
Futures commonly trade at close to the spot price of Bitcoin. The spot price is the current price of the underlying asset at the time of sale. On some occasions, there may be an oversupply or shortage of Bitcoin. If there is a difference in the price of a futures contract and Bitcoin, traders will step in to take advantage of the arbitrage opportunity.
Here is a classic example of “cash and carry” arbitrage; If it costs less to purchase a futures contract than it does to buy the equivalent amount of Bitcoin, you could buy Bitcoin and short a futures contract. When the futures contract expires, deliver the BTC for the agreed price on the futures contract and take the profit on the difference.
What Impact Will Futures Have on the Bitcoin Price?
The purpose of futures contracts is to reduce price volatility and increase market efficiencies. However, there are those that suggest futures are a tool for market manipulation, already preventing real price discovery in the precious metals markets.
An interesting coincidence occurred when, upon the issuance of the first Cboe futures contracts, the price of Bitcoin began to fall from its all-time high. The price rout gained momentum as futures were introduced by the CME Group as well.
Conspiracy theorists attribute the shorting of futures contracts as one of the key reasons behind the December/January bloodbath in the BTC price. Bitcoin whales dump their coins on exchanges and then sell futures contracts, this enables them to earn a Dollar for every Dollar drop in the BTC price.
The Fine Print
Futures markets employ circuit breakers that are activated when the price of the underlying asset moves above or below 20% of the previous days close. Markets close if these circuit breakers are tripped, preventing investors from blowing up their account by being exposed to volatile price action such as a flash crash.
Trading futures successfully requires a degree of market experience and industry insider knowledge. If you have never traded futures contracts before, seek the help of a professional that can give you the guidance you need to get started or consider not trading them at all.