Bitcoin Futures: basic guide

Today’s cryptocurrency market is young and volatile. Cryptocurrencies have no backing, as such their value is not attached to a physical asset in fact. Their prices are, by and large, speculative meaning they are highly dependable on news and people talking about them. In an effort to bring stability to the market, CBOE and CME, world’s largest derivatives exchanges, decided to introduce Bitcoin futures.

What futures are

When you get into a futures contract, you bet whether the asset’s value goes up or down. A futures contract is an agreement between two parties to buy or sell a certain asset at an agreed price at a specific point in future.

When two parties enter a futures contract, one of them takes, what we call, the long position and the other goes short. If you think that the market price of the asset will be higher than the agreed price, you go long. And if your prediction is true, you will profit by buying the asset at a lower price. If your guess is that the asset will cost cheaper than the agreed price, you go short. If it turns out true, you will make money by selling the asset higher than its actual market price.

Futures are a tool for companies to manage risks. Imagine, you have a factory. Your factory consumes a lot of power. You predict that the cost of electricity goes up next month. You offer your power supplier to make a futures contract. According to this contract, next month you will pay for electricity at the current rate. If your supplier thinks that the cost of electricity will go down, they agree. Now you both enter a futures contract: you go long, your supplier goes short. At the expiry date of the contract, you pay for the supplied electricity at the previous month’s rate. And if the cost of electricity did go up during that time, you win.

How Bitcoin futures work

The first and most important thing to know about Bitcoin futures is that they are settled in cash. When Bitcoin futures expire, no actual bitcoins change hands. The losing party in a futures contract pays the winner the difference between the agreed price (the price of a bitcoin when the contract was initiated) and the current price of bitcoin. So the bitcoin market and the bitcoin futures market are completely separate.

Each exchange sets their own standards for their contracts, such as expiry dates and the amount of bitcoins per contract (1 bitcoin on CBOE, 5 bitcoins on CME). What it does is that you can exit a bitcoin futures contract by taking the opposite position in another contract. You will not have to deliver anything to anyone because both your contracts cancelled each other out.

How do I earn money?

Exchanges give you a chance to make money without paying the full price of future contracts. You will cover a portion of a contract yourself and the exchange will lend you the rest of the money to buy a full contract. The amount of money you will need to cover your portion is called an initial margin, and the money you borrow from the exchange is the leverage.

Let’s say you want to start trading on CBOE. Their initial margin for a contract is 44%. And if we suppose that a bitcoin’s price is $1000, and the CBOE’s contracts are standardized at one bitcoin, you will have to add $440 to your account to buy a contract because the exchange will lend you the remaining $560 (1000 - 440). Now you have a contract that is worth $1000 because it stands for one bitcoin, which is at $1000.

Suppose bitcoin went up to $1200. Now you call sell your contract at $1200 and give back the borrowed $560. You end up with $640 (1200 - 560) and, considering that you started with $440, you have just earned $200 (640 - 440).

Of course, in reality it is a bit messier than that because we are ignoring exchange fees for ease of understanding but this should give you a general idea of how you can earn on future bitcoins.

Reminder

They say: 'buy low and sell high™, and remember: futures market is a zero-sum game meaning for every loser there is a winner, and for every dollar lost there is a dollar found.'

DISCLAIMER

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