BitcoinInvestingNews Analysis

Bitcoin Futures Explained

By November 2, 2017 No Comments
The bitcoin market went wild and blew past $6600 when the Chicago Mercantile Exchange announced plans for a bitcoin futures contract. But what does that mean? We break it down for you.

The bitcoin market went wild and blew past $7000 after the Chicago Mercantile Exchange ("the Merc") announced plans for a bitcoin futures contract. But what does that mean? here's everything you need to know.

The Chicago Mercantile Exchange (known to traders as "the Merc") is the world's largest futures exchange, trading 15-20 million contracts daily.  originally founded as an agricultural commodities exchange in 1898 as the Chicago Butter and Egg Board, it still trades cattle, hogs, milk, cheese, and butter. 

You can also buy and sell Merc futures contracts as a way of hedging an investment, or simply betting on the direction of interest rates, stock prices, currencies, energy prices, precious metals, even the weather.

By the end of this year you'll be able to trade - you guessed it - bitcoin futures, on the old butter and egg exchange.  News of the Merc's plans to launch bitcoin futures sent the bitcoin market into a manic frenzy, careening to new high after new high and topping out most recently at $7343. Why all the hype?  Here's why:

What's Weird About Futures Contracts

If you're used to buying and selling traditional assets like stocks and real estate, the concept of a futures contract can at first seem a little strange.  It's a contract that allows you to sell something you don't own, buy something you don't pay for and agree to accept or deliver something that never actually gets delivered.  Weird, right?

Insurance for Farmers

Say you were a farmer growing corn.  A futures contract could give you a hedge against risk and uncertainty about the weather or the value of your crop at harvest time.  You could agree to deliver a certain number of bushels of corn to a speculator on a certain future date (the settlement date) at a specific price (the strike price).

The Merc even has a futures contract that allows investors to bet on the weather.

The Merc even has a futures contract that allows investors and speculators to place a bet on the weather.

Transfer of Risk

Such a contract would give a farmer peace of mind about his future income, and if the speculator made the right bet about the direction of corn prices, he could turn around & sell that contract for more money to other speculators.  So the futures contract gives the farmer a way to transfer his risk and distribute it to the entire futures market.  It also gives the speculator a way to bet on future prices.

Futures contracts are traded based on the price of almost anything you can imagine, including non-physical entities such as interest rates and the S&P 500 index.  They provide a liquid market for investors to hedge and for speculators to bet on future prices.

What is Margin and Leverage?

You don't actually pay for a futures contract.  What you do is keep a certain required amount of money (called "margin") on deposit for every open contract.  So, for example, if you were a currency trader you could hold an open contract of 125,000 Euros with a margin deposit of just $2100.  The actual value of the contract (about $145,000) divided by the margin deposit, is called your leverage.  In this case your leverage is about 69-to-one (145,000 divided by 2,100 equals 69).  Another way of saying this is that every dollar of your margin deposit controls 69 dollars worth of Euros.

Trading volume on the global currency exchange forex is more than $5 trillion a day.  bitcoin has 10x'd its trading volume this year to $628 million daily, but is still minuscule compared to forex.

Trading volume on the global currency exchange forex is more than $5 trillion a day. bitcoin has 10x'd its trading volume this year to $628 million daily, but it's still minuscule compared to forex.

Making The Right Bet

Leverage can work in your favor or against you, depending on whether you've made the correct bet on the direction of prices.  If the price of the Euro, in dollars, changes by one cent, the value of your contract changes by $1,250 - that's a lot of leverage.  A ten cent move in your favor would give you profits of $12,500 - that for a margin deposit of just $2,100!

Of course, there's also a downside to this math.  If you are holding an open position that moves against you then your "open equity" for that contract becomes negative.  In that case you'd have to deposit more money just to keep it open or be forced to liquidate the position for a loss.

These quirky aspects of futures contracts make them very different from actually owning bitcoin.  Once you buy bitcoin, you can't be forced to sell it no matter how low the price goes.  A futures contract, in contrast, would require you to deposit more margin money as the price moved against you.  If not, you'd have to close the position.

Individual investors, like my barber and my mail carrier, are literally tripping over themselves to open coinbase wallets, with new user growth accelerating to 50,000 new wallets a day - that's about 1.5 million per month!

Individual investors, like my barber and my mail carrier, are literally tripping over themselves to open coinbase wallets, with new user growth accelerating to 50,000 new wallets a day - that's about 1.5 million per month!

Long or Short

Which brings us to the other strange characteristic of futures - you can sell something you don't even own.  This is called opening a short position and it's the exact mirror image of buying, which is called opening a long position.

Opening a position, long or short, is just a bet on the direction of prices.  So if you open a short position, your contract rises in value as the price of bitcoin drops.

The Tip of The Iceberg

A Bank of America Merrill Lynch report called cryptocurrency trading a "major new revenue pool" for US exchanges.  Looking at the numbers, you can see why.  The daily volume of fiat currencies traded on Forex, the global currency exchange, is approximately $5 trillion.   Bitcoin daily trading volume has increased more than ten-fold this year alone from $57 million to $628 million, which is still miniscule compared to Forex volume.

individual investors opening wallets on coinbase and other providers have decided to jump into the cryptocurrency space themselves by taking matters into their own hands, but they merely represent the tip of a massive iceberg.

the 50,000 new individual investors who open coinbase wallets every day are willing to go through the hassle of setting up a new online account, linking a bank or credit card, and waiting for funds to clear. they represent just the tip of a massive iceberg - a futures contract would give every currency trader on earth access to the bitcoin market as easily as they access the dollar, euro, or yen.

Individual investors, like my barber and my mail carrier, are literally tripping over themselves to open coinbase wallets, with new user growth accelerating to 50,000 new wallets a day - that's about 1.5 million per month!

And those are people who are willing to go through the hassle of setting up an online wallet, linking a bank account or credit card, and waiting for funds to clear.  Those 1.5 million new investors every month are just the tip of a massive iceberg because a futures contract will allow any speculator to jump into the bitcoin market just as easily as he would with the Euro or the Yen - no special account or wallet required.  And remember, those are the people currently trading more than $5 trillion per day on Forex.

Liquidity and Volatility

A futures contract is likely to increase both liquidity and volatility.  Increased liquidity means there will always be a buyer for every seller, and a seller for every buyer.  Liquidity allows you to initiate and liquidate a position quickly at a price very close to the mid-market price.  Depending on how fast the market is moving and in which direction, you will either suffer or benefit from some amount of price "slippage", but greater liquidity usually means less slippage.

Individual investors will no longer have to overcome the fear of a weird, scary new market.  Combine this fact with institutional deep pockets and you get a tsunami of cash headed for the cryptocurrency market.

opening the cryptocurrency door to every futures trader at the world's largest exchange could bring a tsunami of cash and make bitcoin a player in the $5 trillion global currency market

Market psychology is also likely to affect volatility.  The fact that so many more traders will be trading on margin and heavily leveraged means that there will probably be more stop orders placed close to the market price, as traders tend to more closely protect highly leveraged positions because they can easily get away from you when the market starts moving fast.

So prepare for bitcoin's wild price swings to become even wilder as futures trading comes online.

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