What are bitcoin futures?

What are futures?

Futures is a contract to buy or sell an asset in the future at a certain price. After the conclusion of the contract, the parties are obliged to fulfill its conditions regardless of the market price at the expiration date of the futures.

When dealing with futures, you can open long and short positions. In the first case, the trader agrees to buy the asset at a certain price in the future, in the second – to sell the underlying asset on the day the contract expires.

What are futures for?

These derivative financial instruments (derivatives) are used mainly for speculative profit. With futures, a trader can open both long and short positions using the leverage effect. The latter implies high profitability of transactions, as well as increased risk.

However, initially, futures were invented as a tool for hedging price risks. Thus, through futures, it is also possible to reduce the risks of adverse price fluctuations on various assets.

For example, the main risk for bitcoin miners is a fall in the price of cryptocurrency to a level at which its production becomes unprofitable, that is, the cost of electricity exceeds the income from the mined coins. To secure your business, a miner can sell futures on the number of available bitcoins. If the cryptocurrency exchange rate drops significantly, then the futures will provide an opportunity to offset losses from lowering the price of an asset with profit from a short transaction.

What are the types of futures?

Futures are deliverable and settlement. The former suggest that, at the expiry date of the contract, the buyer must buy, and the seller must sell the underlying asset in the quantity specified in the specification thereto.

An example of deliverable futures is derivatives contracts for oil or wheat. However, here, in the vast majority of cases, transactions are conducted without the actual delivery of the underlying asset, that is, they are purely speculative. Also, operations with deliverable futures are often hedging, in other words, aimed at minimizing price risks. Thus, most deliverable futures close before the expiration date.

Settlement futures initially do not imply the delivery of the underlying asset, but only a monetary calculation in the amount of the difference between the contract price and the asset value at the settlement date. Such instruments are also mainly used for speculative purposes and for hedging price risks.

What is the peculiarity of bitcoin futures?

Futures contracts can be on a wide variety of assets – securities, stock indices, commodities and cryptocurrencies. In general, bitcoin futures are not much different from other derivatives contracts, they also allow you to bet on rising or falling prices in the future.

Note that you can trade derivatives contracts on BTC without possessing the cryptocurrency itself, but only speculating on its price. This is exactly how, in particular, transactions occur on such well-known exchanges as CME and CBOE, oriented mainly to large investors.

However, on the upcoming launch of the Bakkt trading platform, futures will be presented that involve the delivery of physical bitcoin after the expiration of the contract.

What is a futures specification?

This is a document approved by the exchange in which all the terms of the futures contract are fixed, including:

• name of the contract;
• its abbreviated name or ticker (for example, XBT on the CBOE or BTC on the CME);
• description;
• contract size (for example, for CBOE it is 1 BTC, for CME it is 5 BTC);
• type (delivery or settlement);
• the minimum price step (for example, at CBOE it is five points, which corresponds to $ 5 in the USD / XBT pair);
  delivery date and terms of the contract, etc.

What is futures expiration?

This is the termination of the circulation of the contract on the exchange. On the day of expiration, obligations on the futures are fulfilled – mutual settlements between the parties to the transaction are made by paying the price difference (variation margin), or the underlying asset is delivered.

The expiration date is specified in the specification for the futures.

What is the initial, maintenance and variation margin?

Deposit or initial margin – a refundable guarantee fee levied by the exchange when opening a futures position. In other words, this is the amount needed to open a position. Usually 2-10% of the current market value of the underlying asset.

However, in the case of Bitcoin futures, due to the frequent periods of high volatility, the size of the initial margin is much higher in comparison with traditional financial instruments. So, on CME and CBOE it exceeds 40%.

The initial margin is charged to sellers and buyers and is designed to protect the broker from the risk of default on the transaction.

Maintenance margin is the amount required on the account to keep the position open in order to avoid triggering margin call (forced closing of the position by the broker, which entails fixing the loss of the trader and a sharp decrease in his balance).

Access CME and CBOE platforms are provided by brokers (e.g. TD Ameritrade and Interactive Brokers). These companies can set their margin requirements, which may be greater than those of the exchange. For example, the American broker E-Trade set margin requirements for bitcoin futures at 80%.

There is also the term variation margin. This is the amount of money that represents the gain or loss on open or closed contracts. The total value of the variation margin is calculated based on the results of the trading session.

What is contango and backwardation?

Prior to the expiration date, the prices of the contract and the underlying asset are usually different. As the date of execution of the futures approaches, the difference in prices decreases.

Assume that before execution the futures price is higher than the value of the underlying asset. This situation is called contango (Eng. Contango, which literally means “price premium”). In this case, market participants are confident in the growth of asset prices in the future. Contango can occur, for example, before halving a block reward, on the eve of a possible Bitcoin ETF approval or the launch of the Bakkt platform.

If the futures price is lower than the market value of the asset, this is backwardation (from the English. Backwardation – “delay”). This means that the market is dominated by bearish sentiment.

Where else can you trade bitcoin futures, if there are not so many funds for this?

In addition to the CME and CBOE platforms, which are strictly regulated by American laws, bitcoin futures are also presented on platforms such as BitMEX, OKEx, Crypto Facilities, etc.

A feature of such exchanges is the much less stringent KYC procedures and AML policy requirements. In addition, on such platforms, the threshold for entry is much lower, which means that they are available not only for large investors. Also on these exchanges you can trade with a large leverage (for example, 50-fold leverage is available on Crypto Facilities).

How can futures affect the price of bitcoin and the crypto industry as a whole?

Many experts are confident that the emergence of bitcoin futures in the traditional market contributes to the massive adoption and popularization of cryptocurrencies, as mainstream investors will become less skeptical about cryptocurrencies. This, in turn, can stimulate demand and have a positive effect on the price and market capitalization in the long run.

The appearance of traditional financial instruments based on bitcoin actually means its recognition by regulators as an object of investment. The fact that bitcoin futures are gaining popularity on the tightly regulated and largest US market in the world can serve as an example for financial institutions from other countries. Among other things, in jurisdictions where cryptocurrency trading is prohibited, futures allow speculating on the price of their underlying digital assets.

On the other hand, large market participants have the opportunity to open short positions, a large volume of which may put pressure on the price of bitcoin. However, the top manager of the Chicago Mercantile Exchange (CME) Tim McCourt believes that futures do not affect the price of bitcoin, since derivatives contracts for BTC so far represent only a small part of the market. The famous trader Peter Brandt agrees with him, who is convinced that one should not underestimate the influence on the market from a huge number of small bitcoin investors.

At the same time, deliverable futures on Bakkt may serve as an additional factor in the demand for bitcoin. In addition, with the development of this market, the likelihood that the SEC will finally endorse Bitcoin-linked exchange traded funds (ETFs) will increase.

There is also an opinion that bitcoin futures help reduce its price volatility.

Be that as it may, the integration of the cryptocurrency market with the traditional one can potentially contribute to the massive adoption of new assets, and hence their long-term growth.