What are Bitcoin Futures: Trading on a regulated market

 13 min  Beginners  Intermediate

Everything you need to know about Bitcoin futures

The introduction of Bitcoin futures on regulated trading venues was regarded as a significant milestone in bringing the digital currency closer to mainstream investing. While some skeptics still believe that crypto assets are too risky and speculative for long-term investment purposes, crypto enthusiasts hope that futures trading would bring institutional money to the industry. Let's have a closer look at what is a bitcoin futures contract and how to capitalize on it.

In essence, bitcoin futures represent an agreement to sell or buy a certain amount of an asset on a particular day at a price that was fixed beforehand, and to that extent, they are no different from any other derivative financial instrument of the kind, be it futures for corn, oil or soybeans. Companies and businesses buy futures to fix the price for a specific time period, which gives them the luxury of price stability even on volatile markets, while investors often use futures for hedging risks or speculations as the value of the futures contracts is based on the overall performance of an underlying asset.

In December 2017, two Chicago exchanges - CME and CBOE - launched Bitcoin futures trading, and thus unlocked the cryptocurrency market for institutional investors. The exchanges guarantee that the parties of the futures contract fulfill their respective obligations based on the applicable legislation. It means that the market players that were discouraged by an unregulated stance of the digital asset got a handy tool to gain exposure or hedge Bitcoin and benefit from the price fluctuations.

How it works

Speculating on Bitcoin price movements

Bitcoin futures are used to bet on future price movements either to hedge spot market positions or to benefit from both growing and falling market trends without actually owning the underlying asset.

Let's suppose you expect that the price of Bitcoin will grow. To buy a futures contract, you have to provide marginal collateral in the amount of 50% from the contractual value, pay a brokerage fee and exchange fee from $15 to $30 depending on the trading venue.

If the Bitcoin is higher than your futures contract price agreement, you can profit from the surplus. However, if the Bitcoin's exchange rate goes down, you'll incur substantial losses as you will have to pay out the difference and maintain the collateral at the required level.

Speculation on futures price fluctuations

Apart from betting on the way the market for an underlying asset product is going to move, investors can profit from trading futures contracts during their lifetime before expiration. While the price of a futures contract is based on the value of the underlying asset, it may vary depending on the cost of the asset specified in the contract and on the sentiment of the spot market.

Bitcoin Futures Contract Specifications

Large trading venues, like CME and CBOE, set rather high market entry barriers, affordable mostly for wealthy individuals or institutional investors. Currently, CME offers two-month future contracts for 5 BTC with minimum price fluctuation $5 per Bitcoin or $25 per contract and maintenance margin 50%.

The futures price is based on the Bitcoin Reference Rate (BRR) - an aggregated rate across major bitcoin spot exchanges between 3:00 p.m. and 4:00 p.m. London time. As they are financially settled, no real Bitcoins are involved. It means that traders can profit from Bitcoin's price movements without actually owning an asset. CBOE offers Bitcoin futures for 1 BTC with similar trading conditions.

Bitcoin futures benefits

Despite some controversy, these instruments bring a lot of improvements to cryptocurrency markets.

Price transparency

Bitcoin futures contracts are settled every trading day, based on transparent reference price, reflected in all Bitcoin-related contracts. Unified price reference mitigates the volatility of spot prices, making Bitcoin suitable for payment purposes.

Regulation

This is probably one of the most touted and most controversial advantages of Bitcoin futures contracts. Hardcore crypto fans believe that the regulatory environment kills the libertarian nature of cryptocurrency that was born to be free, but the majority of market players are sure that regulation is a necessary step to Bitcoin mass adoption. The futures markets are regulated by Commodity Futures Trading Commission (CFTC), which is not as strict as SEC in terms of oversight. It sets the rules to be observed by all participants, ensuring equal opportunities for investors and speculators, fraud protection and predictability.

Institutional money and enhanced liquidity

Most Wall Street firms and investment funds will not touch anything that is not regulated, while futures offer them an easy way to get involved in operations with digital assets. It means that in the long run, these regulated instruments will attract professional players on the market, increasing the liquidity of both futures contracts and Bitcoin itself.

Leveraged trading

Leverage allows trading many Bitcoins while paying only a portion of the real price. It makes futures trading more appealing to investors as they don't have to pay the full cost of the asset to profit from the price movements. At the same time, it makes trading riskier and may cause significant losses if a trader gets it wrong.

Short selling

Bitcoin futures provide traders with the instrument to short sell, that is to bet on price fall without actually owning the asset. It unlocks investment opportunities for crypto skeptics, namely for those who don't have Bitcoins, but believe that the price will go down.

Bitcoin futures risks

However, there are a couple of flies in this ointment, or risk factors to be considered by potential investors.

Risks of losses

Bitcoin futures are considered to be highly risky instruments due to potentially significant losses. If you are wrong with your price forecast, your money will flow out of your pocket right to the trader who got it right. Considering leveraged trading and highly volatile nature of cryptocurrency markets, the losses may be substantial.

Both CBOE and CME try to mitigate the risks with so-called price limits of 7%, 13% and 20% They are applied both to upside and downside movements relative to the prior day’s Bitcoin futures settlement price. Basically, it means that the exchange freezes the price for two minutes if it goes 7 or 13% up or down and won't allow it to change it more than 20% on a daily basis.

High investor requirements

While Bitcoin futures are supposed to make crypto trading easier and attract new money to the market, they are not readily available for anyone interested. CBOE and CME require 50% as marginal security which is pretty high, especially when compared with 10% margin for traditional assets. Extreme volatility justifies high margin requirements, but they raise the entry barrier for individual investors. Apart from that, both CME and CBOE offer Bitcoin futures trading only for qualified investors, which means that retail investors won't be able to trade bitcoins legally unless they get this status.

Price manipulation risks

Large investors with substantial financial assets can use futures for price manipulations. Thus, placing large sell orders with futures, they create bearish sentiments and force smaller investors to get rid of their assets while it is not too late. The price goes much lower, allowing large players to buy cheap.

A quick round up of key takeaways. What you should know about bitcoin futures

1. Bitcoin futures are derivative financial instruments introduced by CBOE and CMA in December 2017 upon approval obtained from CFTC.
2. Bitcoin futures represent an agreement to sell or buy bitcoins at a fixed price on a specific day. Currently, the exchanges offer are two-months financially settled contracts.
3. Bitcoin futures represent an agreement to sell or buy bitcoins at a fixed price on a specific day. Currently, the exchanges offer are two-months financially settled contracts.
4. Bitcoin futures are traded with leverage, which affects potential profit an loss and may work to investors advantage or ruin their financial position.
5. Bitcoin futures have many advantages against spot crypto market, including higher price transparency, heightened security and short selling option.
6. High investor risks, potential price manipulations, and high investor requirements are the main drawbacks of the instruments that require investors to exercise caution.