If you recall the hype surrounding the launch of Bakkt’s bitcoin futures, you must know just how important bitcoin futures really are. These contracts provide a new way for investors to invest in bitcoin (without the need to hold BTC), but most importantly, they provide a more established and regulated way to invest in bitcoin.
What you’ll learn
- What futures contracts are.
- How futures contracts work.
- Why futures contracts are useful.
- Short and long positions.
- How bitcoin futures work.
- Exchanges where bitcoin futures are available.
- Pros and cons of bitcoin futures.
What are futures contracts?
A futures contract is a legal agreement between two parties to buy/sell a commodity asset at a specified price at a specified time in the future. The buyer of the futures contract is legally obliged to purchase the underlying asset at the specified price at the specified date, while the seller commits to selling the asset at the same specified price and date.
To illustrate this process with a simple example, think of a farmer and a baker. The farmer cultivates wheat and sells it to local bakers, who then use it to make bread. Let’s say that a farmer and a local baker decide to enter into a futures contract. The farmer commits to selling 100 kg of wheat in 2 months time at the price of $1 per kilo. Subsequently, the baker commits to buying 100 kg of wheat at $1 per kilo in exactly 2 months. Once 2 months pass, the contract is executed and the baker gets his 100 kg of wheat for $100, while the farmer gets his $100.
Why use futures contracts?
The reason the farmer and the baker from the above example would be interested into entering a futures contract as opposed to simply buying/selling 100 kg of wheat 2 months from now, is because they both speculate that the price of wheat in 2 months will be lower (in the case of the farmer) and higher (in the case of the baker).
The farmer thinks that the price of wheat will be $0.80 per kilo in 2 months, thus it is in their interest to lock-in the current price of $1 per kilo at the sale date. That way they will profit $0.20 per kilo of wheat – if the price is actually $0.80 in 2 months.
On the other end of the equation, the baker thinks that wheat will be more expensive in 2 months, say $1.20 per kilo. Thus, it is in their best interest that they lock-in the current price so they can purchase wheat at a lower price in 2 months. The baker will also profit $0.20 per kilo of wheat if their prediction is correct.
In short, people can use futures contracts to bet on future valuations of assets.
Short and long positions
In our example above, the farmer bets on the price of wheat going down, which is also known as shorting – the farmer has a short position.
On the other hand, the baker bets on the price of wheat going up, which is also known as going long i.e. the baker has a long position.
Trading futures contracts
One of the interesting features of futures contracts is that they can be traded. This means that anyone can purchase a futures contract and then sell it whenever they feel like it is in their best interest. To understand this, we need to first understand how a futures contract is valued, which is very simple.
Since a futures contract is sort of a wrap around an asset, its value is directly correlated, if not 1:1, with the underlying asset. To put this into the context of our example, let’s say that the price of wheat has jumped to $1.10 per kilo 1 month before the final date of the futures contract.
In that case, the farmer will be sitting at home, thinking whether the price of wheat will continue going up as the 2 month mark approaches. The more it goes up, the more the farmer loses on his wheat. If they decide that it is not worth holding this futures contract, seeing as they will have to sell 100 kg of wheat at a much lower price than the market price, they can sell the futures contract and free themselves from the obligation to sell 100 kg of wheat at $1.
Only the parties holding the futures contract on the expiration date will be legally obliged to buy/sell 100 kg of wheat at $1 per kilo. Obviously retail traders are not interested in owning wheat, but they do use futures contracts to try and make profit. Thus a futures contract can trade hands many times before its expiration date, where the trade therein will finally be executed.
How bitcoin futures work (explained with simple examples)
Bitcoin futures contracts are much like traditional futures contracts for commodities, the only difference being that they wrap around BTC. Bitcoin futures can settle contracts in either cash or physical delivery. Cash settlement means that the two parties that hold the buy/sell ends of a bitcoin futures contract will not exchange bitcoin, but cash instead, while physical delivery means that BTC needs to be exchanged in the end. Let’s illustrate bitcoin futures with a few simple examples.
Alice is an experienced crypto trader who likes BTC. Bob is new to the scene, but has researched a lot and wants to join the game. Alice has also done research and concluded that BTC will go down in price in 7 days. Bob on the other hand, thinks that it will go up in the same week. Current BTC price is, for the purposes of this example, $10,000.
Long position example
To cover Bob’s case, who is going long on bitcoin, he goes on an exchange which offers bitcoin futures contracts (we will cover exchanges in next section) and buys a bitcoin futures contract for $10,000 (current price of BTC). After a week, BTC’s price rises to $15,000 and Bob happily sells his futures contract for a clean $5,000 profit.
Short position example
Now let’s cover the short position of Alice. As established, Alice thinks that BTC’s price will go down in a week. To bet on that, she goes and does what is called short selling. She does so by effectively borrowing a bitcoin futures contract from someone else and selling it, hoping to buy it back later at a cheaper price. To be more specific, Alice sells a bitcoin futures short contract at $10,000 (current market price). BTC’s price then drops to $8,000 a week later. Alice then goes and buys the contract back, receiving $12,000 (the initial $10,000 + $2,000 profit).
Contract expiration and settlement example
To illustrate a contract expiration case, let’s say that Alice and Bob hold two ends of a bitcoin futures contract – Alice bet on the price going down (she has a short position), while Bob bet on the price going up. The price set in the contract is $10,000. At contract expiration date, the price of BTC has gone up to $15,000. Bob is very happy. Call it beginner’s luck.
Since the contract expiration date is reached, Alice is obliged to pay another $5,000 (she has already invested $10,000 to purchase the futures contract). Bob on the other hand will profit those $5,000. Summarily, both Bob and Alice have invested $10,000, but Bob gets $15,000 in the end, while Alice gets only $5,000 in the end. Alice lost $5,000 on her short bet, while Bob made $5,000 on his long bet.
It is important to note here that, for the purposes of simplifying the example, we skipped over a very key feature of futures contracts – leverage – which we will quickly cover a bit later in the guide.
Exchanges where bitcoin futures are available
The Chicago Mercantile Exchange (CME) and Bakkt are the only two regulated exchanges currently offering bitcoin futures contracts. The Chicago Board Options Exchange (CBOE) first started offering bitcoin futures in December, 2017, but stopped offering new contracts in March, 2019.
The CBOE determined the price of BTC using the Gemini exchange index, while the CME averages its price from several reference points. Bakkt use their own index to determine settlement price for bitcoin futures.
The CME offers monthly contracts for cash settlement, while Bakkt offers daily and monthly contracts for physical delivery.
Some crypto exchanges also offer bitcoin futures, though none are CFTC-regulated. These include Binance, BitMEX, and Kraken.
Pros and cons of bitcoin futures
At some point during this guide, your probably thought: “Why not just buy/sell bitcoin?” Well, like with anything else, bitcoin futures have their pros and cons. Let’s quickly list both.
- You can invest in bitcoin without having to hold any BTC.
- You can short bitcoin.
- You have leverage. Let’s say that BTC costs $10,000. If you want to buy one bitcoin futures contract, which is comprised of 1 BTC, you won’t have to pay the whole $10,000 – only a maintenance margin. This is usually a percentage of the price of the contract, which is set by each exchange. A good example is 35%. This effectively allows you to place more bets since you have more capital to work with.
- Bitcoin futures are traded on CFTC-regulated exchanges, making them more trustworthy and lucrative, especially to institutional investors who still don’t have much trust in traditional crypto exchanges.
- Futures are considered one of the riskiest investment instruments.
- Fees tend to be quite high.
- Leverage can be a good thing, but it can also be a bad thing. Considering the volatility of the crypto market, it is not difficult to imagine how a good position can turn into a bad one in the blink of an eye.
- Since bitcoin futures allow large investment institutions to join in on all the fun, sudden spikes in volatility, even in the context of cryptocurrency, might become common.
Summarily, futures are risky investment instruments that allow investors to bet on future price movements of an asset. Investors can take either short or long positions, with the former betting on the price going down, while the latter betting on the price going up.
Bitcoin futures are futures contracts that use BTC as the underlying asset. They can settle in both cash and physical delivery, depending on the exchange that offers them. Cash settlement means that contract holders do not need to hold any BTC as the contract is settled directly in cash on expiration date. On the other hand, physical delivery requires investors to hold BTC, which is then traded on contract expiration.
Regulated exchanges such as the CME and Bakkt offer, respectively, monthly and daily and monthly bitcoin futures, with the former preferring cash settlement, while the latter opting for physical delivery. Crypto exchanges such as Binance and Kraken also offer bitcoin futures, albeit they are not regulated by the CFTC.
Lastly, bitcoin futures come with pros and cons, which is the main reason why investors are strongly encouraged to familiarize themselves with this financial instrument before using it. Some of the pros include investing without holding BTC and the ability to short bitcoin, while some of the cons include high risk and fees.