Futures markets have, for long, been in existence in more established asset classes such as securities and bonds. However, it was not until late December of 2017 that Bitcoin futures were introduced on regulated trading avenues. Although it is the only one of their kind in the digital currency space, Bitcoin Futures is regarded as a significant milestone in bringing cryptocurrencies closer to mainstream investing.
Similar to any commodity/asset futures, Bitcoin futures are not necessarily for maximizing profits but rather serve as a risk management tool to hedge against the risk of the volatile crypto market.
To understand what exactly are Bitcoin futures, it demands we explore how typical futures contracts work in the first place.
What are Futures Contracts?
Futures contracts are basically an agreement between two parties to buy or sell an underlying asset at a predetermined price on a precise future date. Once the contract expires, both parties are obligated to fulfill the terms of the contract at the agreed price, regardless of the actual price at the time of contract execution.
The parties involved usually take one of the two positions of a futures contract; long or short. If you take the long position, it means that you agree to buy the underlying asset/commodity at a specific price in the future, while the short position means the other party agrees to sell the asset at a specific price once the contract expires.
The idea here is to hedge risks associated with adverse price movements of the commodity. If, for instance, you expect the price of a commodity to rise, you can take the long position in a futures contract at the current market price. Upon the expiration of the contract, if the price rose, you’ll have saved some money since the contract will be executed at the lower market price as agreed.
In the same vein, futures can also be used to speculate price movements to realize profits. For instance, if the buying party anticipates that the price of the asset will rise leading up to the expiration date of the contract. They can profit off the price difference, if indeed the price rises, by selling the contract at a higher price to another party, before the expiration date.
How do bitcoin futures contracts work?
Bitcoin futures are similar to traditional financial futures, in that they allow you to speculate the Bitcoin’s price without having to own any Bitcoin.
Investors can either take the long position on Bitcoin futures contract, if expecting prices to increase or short position if they own Bitcoins and want to mitigate potential losses from the anticipated drop in BTC prices.
For instance, say, you own 10 Bitcoins at a market value of $5,000 for each coin, and you anticipate the price will drop to $4,000 in two months. You can take a short position, and agree to sell your Bitcoins at the prevailing market price. Close to the expiration date of the contract, you can decide to buy back (long position) the futures at the now low BTC price, thus earning you $10,000 while saving you the losses caused by the drop in price.
Bitcoin futures unique advantages
I. Regulation
The crypto universe is torn between two major groups; those that want the coin to remain unregulated and those that believe regulation of BTC is an essential step towards mass adoption.
Bitcoin futures are regulated by the Commodity Futures Trading Commission (CFTC). This places BTC on a path to mass adoption. It should be noted that CFTC is not as strict as its alternative, Security Exchange Commission (SEC). So, Bitcoin maintains a good deal of its liberal nature.
II. Enhanced Liquidity
Thanks to the regulatory rules imposed by CFTC, Bitcoin futures are becoming more appealing to professional traders and big money Wall Street investors. With their more dollar volume input, BTC futures may become even more liquid than Bitcoin itself.
III. Price Transparency
Bitcoin futures contracts are settled each trading day using a transparent reference price, which is written into all Bitcoin contracts in other markets. This will make it easy to use Bitcoin as a payment method since transparency creates a unified price that is essential in mitigating the volatility of spot prices.
Getting started with Bitcoin futures trading
Now that you understand how to place and execute a Bitcoin futures contract, there are a few crucial things you need to know for profitable trading.
Get Familiar with the Trading Rules
Trading Bitcoin futures is a bit different from trading typical equities and bond futures. This is due to the fact that they have a significantly higher margin requirement compared to a regular futures contract.
Chicago Mercantile Exchange (CME) and Chicago Board of Exchange (Cboe), the main Bitcoin futures trading avenues, requires one to put up a 35% and 44% margin, respectively, of the futures contract value. Although this margin can be achieved by trading other financial products on the exchange, the products aren’t offered to new traders.
Margin is basically the amount of money a trader must pay first as collateral when taking a futures position. Usually, for most traded assets, the margin is under 10%.
So, this is to say that if a contract was trading at $10,000 on CME, a trader wishing to take a long or short position, will have to pay $3,500. The trader can also be subjected to additional margin calls if the account falls below a certain level.
Understanding Price Limits
Price limits are the maximum price ranges allowed for a futures contract in a trading session. Bitcoin futures are subject to limits on how far the price can move before triggering a temporary or permanent halt.
In the case of Cboe, a contract will be halted for two minutes if the best bid, leading to the contract expiration date, moves 10% up or down the previous day’s prices.
Build a Trading Strategy
Developing a trading strategy is fundamental when trading any type of financing product, including Bitcoin futures.
Your trading strategy should revolve around what you want to achieve – prevent loss or make a profit- while paying attention to your risk appetite. For this reason, consulting an experienced futures broker is recommended, so as to design a personalized strategy that is aligned to your objectives.
Besides, trading directly on CME is almost out of reach due to the high cost a trader is required to pay before they can trade on the platform. As an individual investor, you, therefore, need to find a broker who trades on CME.
Takeaways
One of the best things about Bitcoin futures is that you don’t need a wallet nor BTC coins to participate in the trade. Bitcoin futures, like most futures contracts, are settled in cash equivalents, so no tangible coins are exchanged between parties, saving you the hassle of owning or storing digital coins. Traders collect their gains once the other party honors their contract obligation. Also, you can conveniently place a short without necessarily borrowing the underlying asset ( Bitcoins), meaning you don’t have to own any coins.
As lucrative as it may sound, it is important to keep in mind that Bitcoin futures are a highly risky investment instrument. As such, it is advised to only invest that amount you can afford to lose, should the contract go opposite of what you initially speculated. However, there is always the option to close out a position before the expiration date, in an effort to minimize or entirely avoid losses.