How do Bitcoin futures work?

Bitcoin trading has become a very popular activity even in high financial circles — the rapid growth of the crypto industry is attracting more and more traders and investors. Much of their interest has increased after the previous bull cycle of the crypto market, when Bitcoin futures were introduced on major trading platforms. Today, we will break down the key concepts of this derivative.

What are futures?

First, let’s define the general concept of the term. A futures is a derivative financial instrument. A derivative, in turn, is a financial contract between the parties to the transaction, which is based on changes in the value of the underlying asset (in this case, Bitcoin). A futures contract requires its holder to buy or sell a certain amount of an underlying asset at a fixed price at a specified time. Futures trading is different from spot trading, where the parties trade the asset at its current (market) price.

Let’s consider the application of futures in Bitcoin trading in practice. The buyer wants to buy BTC in the future (say, two months from now) at $30,000. He buys corresponding futures on the cryptocurrency, according to which the seller of the derivative agrees to sell him the coins in two months exactly for $30,000. During this period, the price rises, while the seller of the contract fulfills the terms of the deal and sells BTC at the aforementioned price, which is already below the market price by the time the futures are executed. That is, the buyer can now immediately sell the coins at the market price and make his profit. Conversely, if Bitcoin’s price had fallen in two months, the seller would have benefited.

For the record, “futures contract” and “futures” are the same term. For example, if someone says they bought a futures contract for oil, it means the same thing as a futures contract for oil. By “futures contract,” one usually means a certain type of futures, such as oil, gold, bonds, or S&P 500 index futures. Futures contracts are also one of the most direct ways to invest in oil. The term “futures” is more general and is often used to refer to the entire market.

Why do we need futures?

For cryptocurrency traders, the most attractive feature of futures remains the ability to open trades with leverage. In other words, a trader can get additional funds from the exchange for management against a pledge (margin) of his capital or a part of his capital. Managing considerable sums market players can considerably increase their profits in comparison with similar deals on spot trades, but the risks also increase.

But futures were originally invented as an instrument to hedge risks. These derivatives first appeared in Japan in the 17th century. Back then, the samurai were paid in rice, but because of seasonality and fluctuations in the price of rice itself in the country, they preferred to enter into contracts on the date of payment in an equivalent amount of rice by weight.

In the case of Bitcoin, a similar tactic is employed by miners. For them, the main risk remains the fall of BTC price below the cost of coin production (here we are talking about the cost of electricity and equipment maintenance). To secure his business, a miner can sell futures on the number of bitcoins he has. If the price of BTC does fall, he will cover his losses with the profits from this trading position.

What are the types of futures?

In traditional markets, there are two types of futures — delivery and settlement. The first type of contract implies that by its expiration date, the buyer must buy and the seller must sell the pre-agreed amount of the underlying contract with its physical delivery. For example, if you buy oil futures you will get the amount of oil specified in the contract by the expiration date. However, in most markets cash-settled futures are much more popular; they, too, involve the purchase/sale of the underlying asset according to the above-described scheme, but without physical delivery.

Instead of the asset itself, the parties settle with their cash equivalent. If you take the same example with oil, then after buying a settlement futures, by the expiration date you will not receive the resource itself, but its cash equivalent. Settlement futures are very popular among speculators because they are interested in earning money from price fluctuations and not in owning a certain asset.

Perpetual futures contracts are the most popular on the crypto market. These are the special type of futures with no expiration date. It means that the owner of such futures can keep them as long as he or she thinks necessary. The perpetual futures contracts trade is based on the underlying index of the asset price (Bitcoin), so speculation with these derivatives is very similar to the spot trade, but with one exception: the traders can open leveraged positions, taking additional capital from the exchange.

Another interesting point is that the price of open-ended futures contracts is kept “as close as possible” to the underlying BTC index value, thanks to a financing mechanism. It implies that traders pay out money to each other within a certain period of time, depending on open positions. The difference between the perpetual contract price and the spot price determines who pays and who receives. Thus, when the funding rate is positive, traders with long positions pay shorts, and when the funding rate is negative, shorts pay longs.

Futures Specification

A specification is a document approved by the trading floor that sets out all the terms of a futures contract:

  • Name of the contract;
  • An abbreviated name or ticker (for example, open-ended futures contracts on BitMEX are ticker XBT, on CME — just BTC);
  • Type of futures (deliverable, settlement or open-ended);
  • Minimum step of the contract price (for example, on the CBOE trading platform it is five points or the equivalent of $5);
  • The date of delivery, terms of the contract and so on.

Trading pairs with futures contracts on BTC are also provided by such major exchanges as BitMEX, OKEx, Binance and ByBit. Registration and your deposit are enough to start trading, but to withdraw any substantial sums from the exchange, you will have to undergo an identity verification procedure. This is already standard practice in the anti-money laundering industry.

Bitcoin futures on CME

The Chicago Mercantile Exchange is one of the largest commodities trading floors in the world. CME launched Bitcoin futures in 2017 shortly before the market collapsed and the cryptocurrency industry began a bearish trend.

CME offers contracts maturing in March, June, September and December plus two additional months outside that quarterly cycle. The final value here is calculated according to the standardized bitcoin reference price, which is determined by the CME exchange. The price data comes from leading bitcoin exchanges, including Bitstamp, GDAX, itBit and Kraken.

The CME exchange has developed two standardized indices to determine the strike price of bitcoin futures: the CME CF Bitcoin Reference Rate (BRR) and the CME CF Bitcoin Real Time Index (BRTI). This is essentially the “official” Bitcoin rate from the perspective of the CME exchange. The value of this index determines the strike price of the futures on the day of expiration. BRTI is a real-time Bitcoin index. It is the aggregate value of the Bitcoin price from all crypto exchanges used by the CME exchange to calculate the futures price.

What are contango and backwardation?

Before the expiration date, the prices of the contract and the underlying asset are usually different. As the date approaches, the difference decreases. When the market is dominated by futures transactions with a price higher than the market price of the underlying asset, this situation is called a contango. It indicates the bullish sentiment of traders and usually takes place before the expected positive events for Bitcoin (the next Halving, a new ETF, and so on).

The reverse situation, when the futures price is below the market value of the asset, is called backwardation. In such a case, the market is dominated by bears and there is a very high probability of a new wave of decline of the digital asset.

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Bitcoin-maximalist. Optimistic family man and miner with six years of age. I write about complicated things from the future for people of our days.