The 5 Minute Guide to Bitcoin Futures.
Confused about Bitcoin Futures? You are not alone.
That’s why I have put together a 5 minute guide that will tell you everything you need to know to understand Bitcoin futures.
What are futures?
Normally, when you buy something, the transaction is “settled” immediately. I give you 5 dollars, you give me a three eggplants and we are done. A futures contract is a little different — instead of settling now, we agree to settle at a specific time in the future, for a specific amount.
A futures contract has two parts — the price, and the date of delivery.
So if I agree to give you 5 dollars on Monday for 3 heirloom tomatoes — that’s a futures contract. There are a few more details you will need to know— but that is the essence.
Who uses futures?
There are two main groups of futures buyers.
1: The producers and consumers of the underlying commodity who want to hedge.
For example, If you grow tobacco, you might sell tobacco futures so you can lock in your price, in case the price of tobacco drops by the time you bring your tobacco to market. In the case of bitcoin, the miners fall into this category.
On the other hand, if you produce cigarettes, you might buy tobacco futures, so you can lock in your input costs.
In both cases, you are using futures to hedge against future price changes.
Buying futures hedges against the price going up, and selling futures hedges agains the price going down.
2: The traders who want to speculate on the price movements of futures.
The other group who buy and sell futures are speculators such at day traders, portfolio managers, hedge funds and other institutions. Speculators are drawn to futures because of their high leverage and relatively fast price movements.
Speculators don’t actually deliver the underlying asset (I can sell an oil future without actually planning to deliver a barrel of oil). Instead, the contracts are usually just settled for cash.
What is the advantage of trading futures?
Futures are highly leveraged, which means that a trader only has to put up a fraction of the full contract as margin — but can profit from the price swings of the full contract. This allows a trader to control a large position with a small amount of capital.
Also, futures markets allow traders to take short positions — essentially profiting if the price of the asset goes down. While you can short sell traditional stocks or cryptocurrency, you have to borrow the underlying asset first and pay interest — not so with futures. So futures drastically reduce the friction of short selling.
Are Futures Leveraged?
Yes, as mentioned above — one compelling aspect of futures is that you can control a large amount of an asset with a small amount of cash. The way this works is that you are required to maintain a certain fraction of the value of the futures contract in your margin account. For CME bitcoin futures, that is set at 35%.
Can I buy Bitcoin futures?
Yes, but the CME contract size is 5 bitcoins, so for example, at today’s rate of $14,000 USD each contract is $70,000 USD.
With 35% percent margin required, you will need to maintain a balance of $24,500 just to hold one futures contract.
And keep in mind — if the price move against you, you will be required to add to your margin balance to keep it above the cutoff. For more info on how margin works on futures contracts — see this video from the khan Academy.
All this is to say that the futures market will not be financially accessible for a large number of retail traders — it is better suited to deep pocked individuals and institutions that can weather a $10k+ drawdown without flinching.
Edit: Reddit user Mav-911 points out this correction -
Next week the CBOE bitcoin future will be 1 bitcoin. The following week CME bitcoin future will be 5 bitcoins.
How will the price of futures be related to the price of Bitcoin?
Usually, the price of futures is close to the “spot” price. (Spot price = current price of the underlying asset).
Any large difference in the price will be usually reduced by arbitrage.
Think of it like this: If a futures contract costs more than Bitcoin, you could buy Bitcoin, and sell a future contract at the same time, then, when the contract is up, you deliver the bitcoin for the agreed upon price and therefore profiting on the difference. This is called “cash and carry” arbitrage.
In rare cases, there can exist a large difference between the spot price and the futures price — for example if there is an oversupply of a commodity, or a shortage is expected in the future.
A typical situation will have the futures price slightly higher than the spot price. This is because there is a cost to holding an asset — you have to store it securely for example (no easy task with Bitcoin sometimes).
In addition, you lose out on potential interest on the money you use to buy the asset.
So when you buy a futures contract — you get the benefit of someone else holding the asset for you, and you get to use your cash elsewhere to earn interest in the mean time — which is why thay are usually (but not always!) a little more expensive than spot.
How will futures affect the price of Bitcoin?
Now that is the million dollar question.
In the long run, futures are supposed to increase the market efficiency and reduce volatility.
But in the short run, we could see an increase in volatility as a wave of new participants now has access to the market — both to go long and short.
For an investigation into how the futures market affected gold, see my article : “Will Futures do to Bitcoin what they did to gold?
Are there any more important details?
Yes, there are a few more things you should know:
There is a minimum tic size of $25 per contract — meaning the price cannot fluctuate in increments smaller than 25 dollars per contract (5 dollars per Bitcoin)
Ther is a daily price fluctuation cap of 20% above or below the previous day’s settlement price. Thus is supposed to limit runaway flash crashes which are all too common on current cryptocurrency exchanges.