ELI5 Cryptocurrency futures trading

ELI5 Cryptocurrency futures trading

As the name implies, futures trading implies buying and selling something that will exist in the future. Since you cannot trade a product that does not yet exist, futures trading requires contracts to represent the object of the trade. These are, you guessed it, called futures contracts.

Futures contracts may represent anything – as long as it’s legal.

A car dealer could sell you an automobile in the future and, from a certain date onwards, the contract would have legal value and can be exchanged for a car at a dealership. This type of contract would guarantee futures sales and is normally used for expensive back-ordered cars.

This is an important aspect of futures contracts: they all obtain their object’s market value after a certain date. Before that, the contracts are traded only for the probability that they’ll be worth something on that specific date.

Cryptocurrency Futures

Without further delay, we now take a look at futures contracts that represent cryptocurrencies.

If you’ve ever traded futures at traditional stock markets then cryptocurrency futures will look exactly the same to you. Except your contract object will be crypto and not stocks or agricultural produce.

Bitcoin is, of course, the most popular cryptocurrency currently traded in futures markets.

The idea behind cryptocurrency futures is to own a contract that gives you a profitable right or obligation.

If you buy a call contract, then you must hope the asset price rises above the price you’ll have the right to buy the asset for. This places your contract “in the money” and becomes a profitable deal.

On the other hand, if you buy a put contract, you will be obligated to sell at a given price in the future. You must therefore hope the price of the asset drops below the contract price. Otherwise your contract will be worthless, because buyers would be able to find the asset for a lower price than the contract would entitle them to.

Futures cryptocurrency contracts can be settled in two ways: cash only or in crypto. Now we’ll take a quick look at each settlement method.

Cash Settled Cryptocurrency Futures

As the name implies, a cryptocurrency future is cash settled when it does not involve moving cryptos at all – only cash. While the concept may seem a bit abstract, a short example should make things clearer.

Imagine a futures contract which gives you the right to buy 1 Bitcoin for U$ 4000 on October 1st.

When October 1st arrives, you find that Bitcoin cost U$ 5500. You have a title, backed by a trusted party, which gives you the right to buy 1 BTC for U$ 4000.  You receive U$ 1500 in cash, which is the difference between the price you had the right to buy BTC for and the current BTC price.

This transaction simulates a situation where you had acquired the BTC and then immediately sold it for the current price.

Your futures contract was only profitable because it gave you the rifht to buy U$ 1500 under the current Bitcoin price.

Had Bitcoin been priced U$ 3000 on October 1st, your contract wouldn’t be worth any money whatsoever because there’s no use for a contract that gives you the “right” to buy something for more money than it’s currently worth.

Example of cash-settled Bitcoin futures: CME Group‘s Bitcoin Contracts.

Each CME futures contract represents 5 Bitcoins and its reference price is settled by the Bitcoin Reference Rate (BRR). If you look at the contract specifications, you’ll see that it’s marked as “Financially Settled”:

No Bitcoins at all are moved by this market! Since CME is a trusted market entity, with over 100 years of reputation in the futures markets, its financial instruments are assumed to be safe. That is, all futures contracts will be settled no matter how unfavorable for the house. Being a strongly regulated exchange, based in the USA, also imposes strict requirements for CME. For example, financial instruments must be backed by cash reserves that guarantee a healthy level of liquidity.

Speculators should not assume that every cash settled futures contract emitter should be trusted. Investors should research the emitter of futures contracts and check whether they have a history of honoring such contracts.

Cryptocurrency Settled Futures

You can probably deduce how crypto settled futures differ from the cash settled financial instruments we’ve just discussed? You guessed it: in crypto settled contracts, you actually may opt to receive, or be obligated to send, the cryptocurrency specified in the contract.

In a crypto settled contract, using the cash settled contract scenario just presented, you would be able to execute your right, receiving one Bitcoin and paying only U$ 4000 for it while it would actually cost you U$ 5500 at the current market price.

The value of Bitcoin you hold, using the previous example, would be U$ 5500, which is U$ 1500 more than you paid for it. You can now decide to sell it immediately or hold. Selling immediately would have the same effect as the cash-settled futures contract.

The obvious advantage here is having the option to hold the BTC for the longer term.

Another advantage is that the actual BTC addresses containing the values negotiated in the contracts can be required by investors, thus proving the contracts are indeed backed by BTC. The blockchain’s transparency is a powerful asset in this scenario. The main point being: the Bitcoins negotiated in the contracts must actually exist.

Crypto-settled futures are currently only traded over the counter (OTC) and no major regulated exchanges support this system at the time of this writing.

Crypto Futures Brokerages

You can trade Bitcoin futures at TD Ameritrade, for example. This traditional stock brokerage firm allows you to trade futures contracts. The futures traded are executed by Cboe Futures Exchange (CFE). Special approval is required to trade futures and accounts must be funded with a minimum of U$ 25,000.

TD Ameritrade is featured as an example case. We’re in no way affiliated with any of the aforementioned exchanges or futures dealers.

Conclusion

We hope this simplified introduction to cryptocurrency futures has given you a better idea about how these financial instruments work.

There’s much discussion about the implications of cash-settled Bitcoin futures. For instance, cash-settled contracts need not respect the 21 million Bitcoin hard cap. Since only a reference price is traded, and not actual Bitcoins, more than 21 million Bitcoins could be bought and sold at any given time at the CME board.

Speculators should also carefully weigh the risks involved in futures trading. Futures contracts that are out of the money (like having the right to buy BTC for U$ 4000 and its price has dropped to U$ 3000) are worth zero. Futures can lose 100% of their value simply by not being in the money at the contract execution date. Added with the natural volatility of cryptocurrencies, this makes crypto futures markets one of the most volatile and riskiest trading instruments currently available.

Photo Credit: Lars Plougmann from United States



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