For the first several years of futures markets existence, the CBOT traded grain products like corn, wheat and soybeans. Eventually, other markets were introduced along with other trading exchanges like the Chicago Mercantile Exchange (CME).
In regard to cryptocurrencies, Bitcoin was introduced rather anonymously on 3 January 2009, by Satoshi Nakamoto. For the first few years of its existence, Bitcoin received very little fanfare, as most people simply ignored the cryptocurrency. In 2013, Bitcoin began to enter the mainstream medium when the price began to move relentlessly higher.
During the past five years, the popularity of BTC has exploded. In the wake of Bitcoin’s success, other cryptocurrencies (known as altcoins) have entered the picture. Today, there are several hundred different cryptocurrencies in existence. However, Bitcoin will always be regarded as the first cryptocurrency.
Bitcoin Futures Contract
Thanks to the mainstream acceptance of Bitcoin, the CME introduced a BTC futures contract on 18 December 2017. During the past eight months, other cryptocurrencies have been introduced as futures contracts on other exchanges around the world. As cryptocurrencies continue to gain worldwide acceptance, the demand for cryptocurrency futures will also continue to increase. Many people are being introduced to the futures markets for the first time through their interest in cryptocurrencies. In an effort to better understand the futures markets, let’s review some of the basic facts concerning futures markets and futures contracts.
For starters, there seems to be some confusion between a futures contact and a derivative. Actually, these terms can be used interchangeably because a futures contract is a derivative. In its simplest form, a derivative is nothing more than a security that derives its value from an underlying asset. A Bitcoin futures contract is a derivative because it derives its value from the underlying asset, which is Bitcoin.
In order to explain the workings of a futures contract, let’s use a BTC futures contract in our example. As an investor or speculator in Bitcoin, you have two different options for owning Bitcoin. The first option is to simply buy Bitcoin on the cash market (also called the spot market). Most likely, many of you have purchased Bitcoin on the cash market through a cryptocurrency exchange.
Purchasing Bitcoin on the cash market is a fairly straightforward transaction. For example, if the price of BTC is $7,500, the purchaser simply transfer $7,500 from her/his bank account to the cryptocurrency exchange. In return, the exchange deposits one Bitcoin in your account or wallet. The transaction is complete.
Now, let’s compare a BTC cash transaction to a BTC futures contract. In our example, we will use the standard futures contract issued by the CME. Each futures exchange that issues a BTC futures contract has a slight variation with its contract. However, the basic concept is still the same.
Futures Contract vs. Cash Transaction
The biggest difference between a futures contract and a cash transaction is leverage. For example, when you purchase Bitcoin on the cash market, you must pay the full value upon purchase. A Bitcoin futures contract does not require you to pay the full value of the contact. Instead, you are allowed to make a “margin deposit” which covers a certain percentage of the contract.
In terms of the BTC contract with the Chicago Mercantile Exchange, the margin deposit (also known as the margin requirement) is approximately 48% of the contract’s full value. Let’s review an example.
The standard BTC futures contract at the CME is five Bitcoins. In other words, when you purchase a BTC futures contract, you are actually purchasing five Bitcoins. However, you are not required to pay 100% of the purchase price. As we mentioned a few seconds ago, the margin requirement is 48% of the contract value. The current Bitcoin price is $7,380. One Bitcoin futures contract equals five Bitcoins. Therefore, the total contract value is $36,900(7,380 x 5).
In dollar terms, the margin requirement is $17,712 (36,900 x 48%). Essentially, you own $36,900 worth of Bitcoins for only $17,712. This is known as leverage. All futures transactions are leveraged transactions because you are not required to pay the full value of the contract. Therefore, you have more leverage with a futures contract versus a cash transaction, which requires you to pay 100% of the purchase price.
How Much Can I Make?
How much money can I make (or lose) with a BTC futures contract? This is a difficult question to answer because it depends on a number of different variables. How much money are you willing to risk? What is your profit target on the trade? How many contracts will you purchase? These questions must be answered before you can determine the specific dollar amount of a winning trade (or a losing trade). Let’s review a brief example.
We will make the assumption that you purchased two BTC futures contract @ $7,050 per Bitcoin. As you know, one BTC futures contract equals five Bitcoins. Therefore, you are actually purchasing ten Bitcoins with two futures contracts. The “tick value” of a BTC futures contract is $5. In other words, the contract moves in $5 increments (e.g. 7050 to 7055).
If the tick value is $5, the minimum price fluctuation must be $25. Why? Because the size of a BTC futures contract is five Bitcoins. As a result, the value of the minimum price fluctuation is $25 (5 x 5). In our example, you own two futures contracts. Each time the price moves one tick, you will make (or lose) $50 ($5 tick value x 5 Bitcoins = $25 x 2 contracts = $50).
As we mentioned, your purchase price was $7,050 per bitcoin. Let’s assume you are bullish on the price of Bitcoin, expecting the price to rise to $7,400 within the next several weeks. Consequently, you have a profit target of $7,400. If the price of Bitcoin rises to $7,400, you will sell both BTC futures contracts. Three weeks later, the price hits $7,400 and you liquidate the contracts. You enjoy a nice profit of $3,500 ($350 price increase x 10 Bitcoins).
On the flip side, what if your bullish price forecast is wrong and the price of Bitcoin declines? If you are a smart trader, you will limit your losses by using a protective stop. In our example, you decide to cut your losses at $6,900 per Bitcoin. In other words, if the price drops to $6,900, you will admit that your bullish forecast was wrong and accept a relatively small loss of $1,500 ($150 price decrease x 10 Bitcoins). It’s always a good idea to limit your losses by using a protective stop.
Leverage Creates a Double-Edged Sword
Many traders and speculators love futures trading because of the added leverage. It allows them to purchase additional units of the underlying asset. Therefore, if the trade moves in their favor, they will enjoy a much greater rate of return. Of course, futures trading is a double-edge sword. What if the trade move against you? Unfortunately, the added leverage will certainly magnify your losses in comparison to an all-cash transaction. Therefore, futures trading is certainly not for everyone. If you have an aversion to risk, it would probably be a good idea to avoid futures trading.
The trading of Bitcoin futures contracts is just the beginning for the cryptocurrency universe. As investor demand continues to increase, other cryptocurrencies will be added to the list of futures contracts. In fact, there are currently several exchanges offering multiple cryptocurrency futures contracts. Most likely, the list will continue to grow as we transition into a cryptocurrency society.
Brief Summary of Cryptocurrency Futures Contracts
- Futures trading in the United States dates back to 1848.
- Bitcoin (BTC) was anonymously introduced on 3 January 2009.
- The CME introduced the first regulated BTC futures contract on 18 December 2017.
- A derivative is a security that derives its value from an underlying asset.
- A BTC futures contract is a derivative.
- There are two ways to purchase Bitcoin, cash transaction or futures contract.
- A cash transaction requires the buyer to pay 100% of the purchase price.
- A futures contract allows the buyer to place a margin deposit with the exchange.
- The margin deposit does not cover the full value of the futures contract.
- A futures contract is a leveraged transaction.
- Leveraged transactions carry a high degree of risk.
- If you have an aversion to risk, you should avoid the futures markets.
- Cryptocurrency exchanges are now offering multiple futures contracts in addition to BTC.