Bitcoin basics: how Bitcoin futures work

By: Tim Bennett
Bitcoin futures allow big institutions to enter the cryptocurrency market for the first time – here’s how and what this could mean for everyone else.

Bitcoin basics: how Bitcoin futures work

The latest innovation to hit the cryptocurrency market is the creation of Bitcoin futures that can be traded on some of the world’s biggest exchanges. So, here I take a quick look at what they are and how they may impact the Bitcoin market. I will start by also issuing a warning to novices – interesting though they are, derivatives on something as volatile as bitcoin are not suitable to most investors, for reasons that will soon become clear.

It takes two to tango

A future is just a contract, agreed between two parties, which derives its value from an underlying asset – in this case, Bitcoin. Each party takes a different view on the future direction of Bitcoin but without ever having to buy or sell Bitcoins themselves. So for example;
You might be wondering why someone who is bullish about Bitcoin prices wouldn’t just buy Bitcoins. The point is they can, but with futures (and spread bets/CFDs, which are mechanically similar in many ways) they get a leveraged position, using a product that many professional traders are already familiar with – the futures contract. For Zoe, above, the attraction is that futures allow her to bet on falling prices, again using leverage. This can be highly dangerous if the bet backfires but nonetheless it is not something that she can do in the Bitcoin market itself.

A simple example

In order to place a bet on the direction of Bitcoin, you either buy, or sell, futures. The price of the contract is agreed up front – here $20,000. This assumes that one futures contract is written on one Bitcoin. In practice the number can be higher, which increases the “contract size” and the scale of the associated trade. In this example, Tim and Zoe decide to buy and sell 5 contracts, the equivalent of buying 5 Bitcoins.

Some admin points

Exchanges, such as the Chicago Board Options Exchange or the Chicago Mercantile Exchange (the earliest of the big exchanges to offer futures) need to decide certain things up front that will then apply to all participants. Key amongst these are;

·         How many Bitcoins there will be per contract (1? 5?..)

·         What reference price will be used to settle up profits and losses

On the latter point, you need a price to compare to the original contract price of $20,000 to work out how much one party must pay to the other. This reference price may be determined in different ways, depending on the exchange in question. The CBOE, for example, uses the price given on a well-known platform called Gemini on the date a Bitcoin futures contract expires. The CME on the other hand prefers to average several reference prices obtained from different sources.

What happens next?

If we roll forward, we will find out who has won the bet between Tim and Zoe. That’s because the market price of Bitcoin – and therefore the reference price above – will move. Let’s say it goes up to $25,000. This means Tim has won the bet, to the tune of $5,000 per contract, or $25,000 in total. This money is paid by Zoe, via the relevant exchange clearing house. In practice this amount will have been paid across by Zoe bit by bit as a function of the “daily margining” of futures contracts.

Introducing leverage

Professional investors are attracted to futures in part because bets can be geared up to generate more “bang per buck”. Let’s use the same example but assume that the minimum margin required by the exchange to open a bet is 20% of the value of the contract. This means that both Tim and Zoe can open up bullish and bearish bets with a value of $100,000 but only need to fund $20,000 at the outset.
When the contracts are settled, using the reference price of $25,000 per contract, Zoe has still lost $25,000 and Tim has won this amount. This means Tim and Zoe’s profits and losses on their original stakes have been magnified (up to 125%, from 25% under the first scenario) thanks to margining – in Zoe’s case her loss is more than her original deposit so the clearing house will have been calling on her to put further cash on deposit to fund the outstanding debt. It is this aspect of futures (and spread bets/CFDs) that makes them very risky.

Just remind me – why not just trade Bitcoins?

Traders using futures exchanges like the fact that they can achieve the leverage above through the margining system. They also like the fact that there is a central counterparty guarantee sitting behind every trade so that bets are essentially honoured. Most importantly though, they like the fact that someone like Zoe can bet on falling as well as rising prices using futures. Of course, all of these features make the futures market unsuitable for many investors, as the potential cost of getting a bet wrong can be huge and is not limited to your initial deposit.

What lies ahead?

It is still very early days in the development of a fully-fledged futures market. There are quite a few issues that still need to be ironed out, such as the maximum size of bet any single participant can take – a “position limit” – plus the disagreement over the reference price that is used to settle contracts.
Everyone will also be watching closely to see what the impact of big institutional players taking a view on prices, through this new mechanism, will be. Bulls say it will add credibility and weight to the buying wave whilst bears say Bitcoin’s days as a rising asset are now numbered – big sellers now have a mechanism to bet against cryptocurrencies.
Further, the advent on Bitcoin futures almost certainly presages heavier regulation across the industry as a whole at some point. Both the US SEC and the UK FCA are paying much closer attention to the booming Bitcoin market, concerned that some degree of investor protection needs to be imposed, and quickly.
Whichever side of the debate you are on, one thing is for sure – any instrument that allows you to take leveraged positions in something as price-volatile as Bitcoin is potentially very risky indeed. For most wannabe investors the advice is therefore simple – by all means try to understand Bitcoin futures (and spread bets/CFDs) but steer well clear when it comes to investing your own capital. You have been warned!