Insights Into Bitcoin Futures Contracts: Part 1
In December last year, Bitcoin achieved an all-time high of around $20,000 USD. One of the main factors that influenced such a price increase was the introduction of a futures contract on Bitcoin. Although the gains largely preceded the launch of the futures contract, they were partly driven on expectations of a new derivatives product being offered by CBOE/CME. In this article, I will try to explain the principle of a futures contract and how it can impact bitcoin’s price.
On 10th December 2017, CME Group launched trading in bitcoin futures, and a week later such actions were carried out by its competitor Cboe Global Markets.
The launch of CME futures has increased the legal status of cryptocurrency and has also boosted investor interest in the digital asset. The key question here is: how can this instrument make you additional money?
What are Futures Contracts?
In the world of trading, there are many different ways to buy and sell assets on exchanges, and some of them are very risky, such as margin trading. Futures contracts are a way to transfer risk, depending on how aggressively you want to trade. This concept is not new, as it has existed for decades and now applies to Bitcoin.
A Bitcoin futures contract is an agreement between two parties to a transaction that buys or sells BTC at a predetermined price at a future date. That is, the futures buyer acquires the right to sell BTC coins in the future at a fixed rate, and the futures seller announces his consent to accept the cryptocurrency on the settlement date at a fixed price.
History of Futures
The idea of creating futures contracts was initially to protect manufacturers and suppliers from sudden or significant fluctuations in commodity prices. This is a written agreement that determines the size (quantity), cost, evaluation (quality) and conditions for delivery of the goods on a specific date in the future. These instruments are traded (bought and sold) between producers, dealers or speculators (i.e., traders seeking to profit from price movements).
The first registered commodity futures transactions for the sale of rice occurred at the beginning of the XVII century in Japan. These contracts also made their way to the United States in the early 1800s when many agricultural products began to be produced. Most of these products had a limited shelf life, and the quality of stored products usually deteriorated over time, so the prices could vary significantly. Therefore, the first contracts for the future price appeared, which allowed the seller to get money for the goods before delivery.
The first American exchange was established in 1848 and was called the Chicago Board of Trade (CBOT). Its creation was preceded by the emergence of railways and telegraph, which connected the trading center with the agricultural market.
A group of brokers working in this council was able to establish a standardized and more efficient method of exchanging goods, thanks to the launch of futures contracts on the exchange. Instead of managing numerous individual agreements between interested parties, they developed futures that were identical in terms of asset quality, delivery dates, and conditions, and simplified the entire process of buying and selling future supply at the current price.
How Do Futures Contracts Work?
In practice, futures contracts look like this. For example, a farmer concludes futures agreement with a dealer that he will supply him with 10 tons of corn in early August. Both parties to the transaction receive their “guarantee” – the farmer will be paid a certain amount for the corn, and the dealer fixes his buying price in the future.
Such agreements became very widespread, and are even used as collateral for bank loans and can also be transferred. If the farmer decided that he will not sell his corn, he can directly sell his contract to another farmer. A dealer may also do so; if his plans have changed and he no longer needs corn, he can always resell his futures on the exchange to another intermediary.
In Bitcoin futures, you also fix the price and a certain number of coins that will be sold or bought in the future. It is a tool to transfer or accept the risk. Parties to the agreements may take different positions:
- Buyers who have a hope to buy coins at a better price when the value of the asset increases enter into a trade from a long position.
- The selling side works from a short position, which will be able to get a more attractive price in the future, having successfully sold its product when its value starts to go down.
On the trading floor futures contract can be used throughout the duration. The parties may also place money in escrow to reduce the risk of the counterparty during the term of the futures contract. This is usually done only when the price begins to show strong movement to a long or short position held either by the buyer or the seller.
Types of Futures
There are two separate types of futures contracts:
- Physical delivery futures, which are an agreement for a specific asset that will be transferred at the end of the term of the futures. An asset can be any commodity or money (oil, grain, cryptocurrency, gold, etc.).
- Trade or settlement (non-deliverable) futures, which are a type of contract that involve the conclusion of an agreement without physically transferring the object.
Bitcoin futures produced to-date are the settlement type of the trade agreement since there is no physical transfer of the asset. All financial transactions on futures contracts are a practical tool in trading since they can perform two actions:
- Hedging (insurance of price movement risks)
- Speculation (the possibility of quick earnings on the difference in the value of the subject of the transaction)
Players involved in speculation are very interested in bitcoin’s price volatility because it gives them the opportunity to open short and long positions several times a week and make good money. Experienced traders who use technical analysis to predict movements in the market quite often make profits on futures transactions with Bitcoin.
In the next article, I will speak more about terms of BTC futures and where one can trade them.
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