Bitcoin Futures: Everything to Know
By Beluga Research September 25, 2023
- Bitcoin futures are derivative contracts that allow investors to speculate on the future price of Bitcoin without owning it
- A contract for a bitcoin future allows an investor to bet on whether bitcoin will go up or down in price by a predetermined date
- The party to the contract who is incorrect about the direction of bitcoin's price pays the other party a specified amount
- Each bitcoin future contract usually represents 5 bitcoins
Bitcoin futures are derivative contracts that allow investors to speculate on the future price of bitcoin without owning it. The concept of bitcoin futures is borrowed from the traditional finance world. There are futures contracts for fiat currencies, stocks and commodities. Bitcoin futures are often traded on regulated exchanges such as the Chicago Mercantile Exchange (CME).
A number of bitcoin futures involve monthly contracts that expire on the last Friday of every month. Bitcoin futures allow investors to control large positions with a low amount of capital. They contribute to price discovery, defined as finding the price of an asset like bitcoin. These futures also offer hedging opportunities. Although bitcoin futures operate in a regulated environment, they come with risks, including volatility, margin calls and counterparty risk.
A Brief History
Bitcoin futures were introduced in December 2017 by the CME and the Chicago Board Options Exchange (CBOE). This marked a significant milestone in the adoption of cryptocurrencies. The offering gave institutional investors a regulated platform to trade bitcoin derivatives. As of 2023, the CME allows investors to become party to monthly contracts for six months. It also offers quarterly contracts for the four upcoming quarters.
Bitcoin Futures: Everything to Know
- How Bitcoin Futures Work. Bitcoin futures operate on the principle of a forward contract. Two parties agree to buy or sell an asset at a future date for a predetermined price. These contracts are settled in cash rather than the physical delivery of bitcoin. Investors can take long or short positions when buying bitcoin futures. A long position involves buying bitcoin futures with the expectation that the price of bitcoin will rise. A short position involves selling bitcoin futures with the anticipation that the price will decline. Investors can profit from both upward and downward price movements.
- Price Discovery and Market Liquidity. Bitcoin futures markets play a crucial role in price discovery and market liquidity. By allowing investors to speculate on future bitcoin prices, these markets provide valuable insights into market sentiment and expectations. Continuous trading of bitcoin futures contracts enhances overall liquidity in the cryptocurrency market. It facilitates easier entry and exit at desired prices.
- Leverage and Margin Trading. Bitcoin futures offer leverage, enabling investors to amplify their exposure to bitcoin's price movements. Leverage allows investors to control larger positions with a smaller amount of capital. Leverage can increase profits but raises the risk of losses. Investors should exercise caution and thoroughly understand leverage and margin requirements.
- Regulation and Risk Mitigation. Bitcoin futures trading is subject to regulatory oversight to ensure fair and transparent markets. Regulated exchanges establish rules and monitoring mechanisms to prevent market manipulation, fraud and illicit activities. Risk management tools such as position limits and circuit breakers are in place to mitigate volatility and protect participants.
- Open an account. An investor should establish an account with a regulated futures exchange that offers Bitcoin futures. They should choose a reputable and reliable exchange that ensures fund security and compliance with regulations.
- Deposit funds and start trading Bitcoin futures. The investor should diversify investments so they do not have all assets locked into bitcoin futures.
- Learn from the experience. Whether the investor sees a profit or a loss, they should look at what drove the price of bitcoin up or down. They should understand the effects of certain events like a security breach. They should incorporate this knowledge into their next venture involving bitcoin futures.
- The underlying asset is bitcoin. Bitcoin is highly volatile and subject to significant price changes. Although it is regulated by governments and financial institutions, it operates independently of any central authority.
- Two settlement methods. Bitcoin futures contracts can be settled by cash settlement or physical delivery. Cash-settled contracts are settled in fiat currency, usually U.S, dollars. The amount is based on the difference between the contract price and the spot price of bitcoin at expiration. Physically settled contracts require the actual delivery of bitcoin upon contract expiration.
- Allow investors to take both long (buy) and short (sell) positions. This means investors can profit from rising and falling bitcoin prices. Shorting bitcoin futures enables investors to benefit from price declines by selling contracts they do not own. The aim of shorting is to buy back the contracts at a lower price in the future.
- Available 24/7 . The constant availability of the market for bitcoin offers flexibility for global investors. It allows them to react to market developments at any time.
- Hedging. Bitcoin futures enable investors to hedge their positions in the volatile cryptocurrency market. Taking long or short positions on bitcoin futures helps investors offset potential losses in their holdings.
- Price Discovery. Trading bitcoin futures on regulated exchanges contributes to price discovery in the cryptocurrency market. Futures prices are determined by market forces. The futures prices reflect the expectations and sentiments of market participants. Transparency helps investors make informed decisions and assess market sentiment regarding bitcoin.
- Leverage. Bitcoin futures offer leverage, which amplifies potential profits.
- Liquidity. Bitcoin futures markets are highly liquid and have many active participants. This ensures easy entry and exit from positions without a significant impact on market prices. High liquidity also leads to tighter bid-ask spreads, which reduces trading costs.
- Regulated Environment. Bitcoin futures trade on regulated exchanges that provide oversight and investor protection. Regulatory bodies impose rules and regulations to promote fair trading practices and prevent market manipulation. This instills confidence in the market. It attracts institutional investors and fosters greater adoption of bitcoin futures.
- Volatility. Bitcoin futures are subject to price fluctuations. The cryptocurrency market's high volatility can lead to significant price swings in futures contracts. Investors must be prepared for risk and uncertainty.
- Margin Calls. Trading bitcoin futures with leverage requires maintaining a certain margin level. If the futures contract moves against the investor's position, a margin call may occur. This requires adding funds to meet margin requirements or facing position liquidation. There is a risk of losing more than the initial investment.
- Counterparty Risk. Bitcoin futures involve counterparty risk. This is because investors rely on exchanges to fulfill obligations. While regulated exchanges minimize this risk, default or insolvency is still possible. Choosing reputable exchanges mitigates counterparty risk.
- Market Manipulation. Despite regulatory oversight, the cryptocurrency market is susceptible to manipulation. Price manipulation can distort the value of bitcoin futures contracts. This can result in losses. Investors should remain aware of the possibility and impacts of market manipulation.
- Complexity. Bitcoin futures trading can be complex, especially for novice investors. Understanding futures contracts, margin requirements and trading strategies requires knowledge and experience. An investor can develop a successful strategy by educating themselves, taking time to understand the crypto market and determining their risk tolerance.