Understand cryptocurrency futures

Understand cryptocurrency futures

Trading futures is an art. It’s probably one of the riskiest investment games you can play, since futures contracts don’t actually represent a current asset, but something that is still going to happen. The level of uncertainty when dealing futures is magnitudes larger than when buying stocks. Add this to the usual volatility of the cryptocurrency markets and you’ve got TNT.

In this article we take a look at cryptocurrency futures, how they’re traded and the risks involved in this kind of investment.

First of all, what is actually a “future”? What we call a “future” is actually a contract. A piece of paper, or digital agreement, where you agree to pay a certain amount for a certain asset, or you agree to sell a certain asset for a certain amount. You might ask why would anyone do that? It turns out that this kind of derivative is great for hedging yourself against future price variations.

If you know you’ll need a certain amount of corn for your farm in exactly 6 months, but you’re not willing to pay more than a certain amount for this corn, you can enter an agreement with a corn producer to buy a certain amount of his production for a certain price. The producer wins because he has guaranteed the sale of a certain amount even before he has sown the corn seeds, and the buyer wins because they’ve guaranteed the supply of a certain amount for a certain price. All this is fine and dandy and this is why futures exist.

It just so happens that someone that has never owned a farm and doesn’t need a single kernel of corn can also buy these futures solely to bet on its future valuation. How does this work? If you sign a futures contract to buy corn for $15 and there’s a serious drought and corn soars to $60, suddenly your contract is worth at least $45, which is the spread from the target price and the market price. This is how futures are used for speculation: in the above example the futures contract has gained 300% value in a few months, something unthinkable in any other kind of investment.

But what if there is abundant production of corn and its price falls to $5? What will you do with a contract that guarantees you can buy at $15? Nothing! The contract isn’t worth a dime any more because the price it guaranteed your purchase for has become much lower in the market. You can buy cheaper corn without this contract. In this case the futures contract is worth zero. You might as well rip it apart and trash it.

As you can see, futures are a risky game. Some make fortunes, others lose 100% of their investment. Although stocks also allow you to lose 100%, it’s very rare for a blue chip to go bust and for its stock to collapse so dramatically in such short span of time. There are usually ample warning signs for stock holders before such a catastrophic market situation happens. With futures anything can happen overnight and 100% losses are not uncommon.

Bitcoin Futures

Everything we’ve just said about corn applies to commodities in general and also to Bitcoin futures. Suppose you’d like to buy Bitcoin 6 months from now when you plan on getting paid for a project. You want to guarantee that you can buy Bitcoin for today’s price, or $7500. You can then buy CALL options for $7500 with target date 6 months from now. Or maybe you wish to guarantee that you can sell your Bitcoins for $7500 6 months from now, because you fear it may fall below the current market price. You then buy a PUT option for $7500 betting that Bitcoin will lose value in this time. If Bitcoin gains value instead, this PUT option will become worthless.

Where can you trade Bitcoin futures? Same place you can trade corn or oranges: Chicago! The Chicago Mercantile Exchange (CME) launched Bitcoin futures and allows you to trade these contracts just like you would any other commodity. BitMex and OKCoin also allow you to trade futures and have lighter Know Your Customer (KYC) requirements than CME which is fully regulated. In order to trade at CME you need to be associated with an accredited broker or brokerage firm where all the usual client information will be registered. Opening a brokerage account in the USA has become stricter post 9/11 and all other regulated exchanges must obey these strict requirements.

Conclusion

We hope this article has provided a clearer view of what it means to trade Bitcoin or any other cryptocurrency futures. Futures are a very risky investment when used as a speculation tool, but they can be of vital importance when you must actually buy or sell the assets in the futures contracts. Companies which depend on commodities trade futures in order to guarantee certain prices in the future and not for speculative purposes. Businesses which depend on foreign currency exchanges (FOREX) also use commodities to hedge their risks. Bitcoin futures are traded just like commodity and currency futures and obey the same rules.

 

 


Chicago Mercantile Exchange / President Bush Photo Credit: The White House
(Photo author information missing from White House website at time of writing / May 2018.)



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