For ages, finance has been going through continuous evolution and a series of innovations. New technology and methods help ease access to money and create intriguing ways to interact with value. In the present market, we can see a number of financial instruments available for different functions. With the recent advent and popularity of cryptocurrencies, innovations have gained a new pace.
Bitcoin is the largest cryptocurrency by capitalization but is as volatile as others. Trading physical tokens forces the trader to exchange them at their present price.
However, like any other financial instrument, there is a way to hedge and speculate on the future prices of Bitcoin – in the form of Futures Contracts. In this post, let us try to understand what Bitcoin Futures are and whether they are an effective way of trading in cryptos.
What Are Bitcoin Futures?
A financial derivative product, futures is essentially a contract between two parties where they agree to buy or sell a digital asset at a price decided in the contract on an agreed date in the future.
The price of the contract keeps changing over the period from everyday trading activities. When talking about Bitcoin Futures, the underlying asset is Bitcoin. These futures have a selling price, a future price, and a maturity date.
Uses of Bitcoin Futures
Bitcoin Futures allow traders to hedge against volatility in the market and provide them a way to buy or sell the crypto at a predetermined price in the future. Rather than buying and selling Bitcoin which requires setting up a cryptocurrency wallet and using exchanges, futures lets traders gain exposure to the digital currency and benefit from the price movements.
Bitcoin futures allows tracking price movement of the crypto asset without using a digital wallet. They also let you hedge against the future price of the currency. Another benefit of futures is leveraging through margin account for higher potential gains. Moreover, bitcoin futures are tradable and hence quite liquid.
The primary job of Bitcoin futures is to allow speculating on the future price of the coin. This means you can buy a futures contract if you expect that the price of Bitcoin will be $50,000 after three months. If the price stated in the contract is $30,000, you would be able to buy Bitcoin at this price instead of the market price and thus earn money. Bitcoin futures contract is traded on the Chicago Mercantile Exchange (CME).
How Bitcoin Futures Work?
Futures work differently as compared to trading in funds, stocks, and other fixed-income vehicles. Bitcoin Futures involve no exchange of physical coins; you speculate on the price of the asset and not buy or sell the underlying asset itself.
There is also no need for a cryptocurrency platform or wallet. Futures contracts are settled on the expiry date or offset by traders as they exit their positions before the date.
If a trader holds a position in bitcoin futures and the market price of the coin increases the price in the contract, he receives the difference as profit; he bears the loss if the price moves otherwise.
The three primary components of a Bitcoin Futures contract are:
Expiration Date – This is when the futures contract should be settled. It is the agreed date on which the parties should buy and sell the asset at the pre-decided price. However, traders can sell their contracts to others before this date if they want.
Units per Contract – This varies between platforms and is a specification of how much Bitcoin a contract has. For example, a CME bitcoin futures contract equals five bitcoins.
Leverage – Traders are allowed to borrow capital and expand their trade size to increase the potential gains from their futures bet. Different platforms have varying leverage rates.
Traders can settle Bitcoin futures in one of two ways.
Physical Delivery – Upon settlement, the buyer can choose to receive physical bitcoins.
Cash Settlement – In this method, there is a transfer of cash between the two parties upon settlement.
Crypto-based futures products have gained massive popularity in the past few years. Today, you can find a number of traditional as well as crypto-based platforms that allow trading in bitcoin futures. Some of the most popular platforms in the market include CME, BitMEX, eToro, FTX, Kraken, Bybit, TD Ameritrade, Deribit, and more.
Risks of Bitcoin Futures Trading
While there are so many benefits of trading Bitcoin futures like leveraged trading to boost potential gain and indirect exposure to the currency, this trading method also has some risks associated with it that traders should be aware of. The primary risks are liquidation and margin calls.
Trading with leverage involves borrowing funds from the exchange you trade on to increase the size of your trade and your gain. A platform doesn’t let you borrow without putting in some kind of insurance in case the trade turns against you.
This is called the ‘initial margin’ a trader needs to set aside before entering a leveraged trade. The margin is kept in a margin account and a maintenance margin must be kept ready for deposit in case the initial margin runs out.
In case the market goes against the trader, the margin account gets quickly depleted and something called ‘liquidation’ takes place whereby the trader’s position is automatically closed by the exchange and the initial margin is taken up.
Looking at the high volatility of the crypto market, it can be said that there is always a high risk of getting liquidated and losing all your capital. Investors can always keep refilling their margins to keep the positions open in a hope of getting the desired price movement, but this further adds to the risk.
Final Thoughts
Bitcoin is the biggest part of the growing cryptocurrency landscape. Bitcoin futures provide investors an opportunity to make a profit from future price movements of the asset without having to hold it physically. However, one should understand the obligations of a futures contract, volatility of crypto assets, and risks associated with this trading method before investing in Bitcoin futures.
