Bitcoin Futures became mainstream after they were adopted by the Chicago Mercantile Exchange, CME Group, in 2017. Understanding the working mechanism of Future contracts and Bitcoin futures is necessary to get a grasp of how this financial instrument affects the price of Bitcoin in the traditional market.
The word Future contract already suggests what they are - a contract where an agreement for the future is made in the present.
A future contract or simply put, futures, is an agreement that guarantees that market participants will buy/sell a specified amount of an asset at a specified future date, at a pre-agreed price.
They are standardized agreements that are typically traded on an exchange. These contracts have some data defined such as the quantity, price, and expiration date of the contract. The buyer undertakes to purchase a certain quantity of securities or a commodity and to take it over at a certain point in time at a previously agreed price. The seller of the contract on the opposite side undertakes to make this agreed quantity available at the agreed price. Upon expiration of the contract, payments are made according to what is stipulated in the contract.
This financial instrument was launched by the Chicago Mercantile Exchange CME Group and initially allowed the trading of assets like stocks, gold, and oil. It added Bitcoin futures in 2017. In 2021, CME added Ethereum futures to tradable assets and it became the first altcoin traded on the US stock exchange.
To better understand how Futures contract work, let's take a look at an example.
For example, you want to buy 1,000 tons of rice from a producer at $500 per ton and thus, you and the producer entered a 5-months future contract for a value of $500,000. This means that in 5 months, you will be able to have access to the rice that you have bought, and you will be able to sell it or use it as you wish.
After 5 months, the price of a ton of rice increases to $550 due to higher demand or increased production. Since you bought 1000 tons of rice at a lower price, your contract will be a positive contract which generates a profit of $5000.
Bitcoin futures (BTC) are derivative contracts, or Bitcoin financial instruments traded on an exchange, in which the modalities and conditions of the future delivery of the BTC are established.
Bitcoin futures use the same trading scheme already described, only this time, the purchase or sale is based on variations in the price of Bitcoin. Investors often use futures to speculate on the price of Bitcoin in a regulated financial market (or not) to make a profit without having to hold Bitcoin in a wallet. All this while you get great leverage opportunities that multiply your profits. However, this means an equal opportunity for huge losses.
In addition to this, Bitcoin futures have quite different features from what we see in the traditional futures market in that a good part of Bitcoin's future market is not subject to any regulation. This is because Bitcoin is a cryptocurrency and therefore it is not recognized as a legal tender in many countries - there is a certain legal vacuum in this regard.
On the other hand, companies that offer Bitcoin futures operate in areas with no legal restrictions. Currently, the most commonly used regulated Bitcoin futures are CME, Bakkt, and CBOE futures. Other markets that offer unregulated futures include Binance, OKex, Huobi, and Kraken. The sheer number of options may make it seem like futures trading is very safe and easy. But the reality is, the highly volatile nature of cryptocurrencies like Bitcoin makes futures a risky investment tool not suitable for the average user.
Bitcoin futures trading has distinctive features compared to spot trading since it does not require buying, selling, or holding BTC. Instead, futures traders buy or sell futures contracts that represent the value of Bitcoin at a certain date in the future. In contrast, assets in spot trading are exchanged instantly.
Although futures contracts can be denominated and settled in fiat, some contracts are settled in BTC - however, this is not a necessary condition for trading bitcoin futures. Bitcoin futures allow investors to speculate on the future value of BTC. For example, traders can go long and bet on a price rally, or they can go short if they expect the BTC price to retrace.
The standardization of Bitcoin futures contracts is determined by each futures exchange. For example, bitcoin futures contracts on the Chicago Mercantile Exchange (CME) are for 5 bitcoin and are quoted in United States dollars (USD). There is another type of contract called Bitcoin microfutures, which was introduced by CME in March 2021, in which each contract corresponds to 0.1 BTC.
There are two types of Bitcoin futures contracts on Binance: those denominated and settled in Tether (USDT) and those denominated and settled in BTC. For those denominated in BTC, each Bitcoin futures contract costs $100, which determines the specific amount of that cryptocurrency associated with each contract at the time of purchase. The maximum exposure allowed to a trader on Binance, through Bitcoin futures contracts, is 1,000 BTC.
Bitcoin Spot Trading Vs Bitcoin Futures Trading
Let's have a quick run through an example of what a Bitcoin futures contract looks like:
Bitcoin's current price might be $27,500 - and a 3-month futures contract might have a strike price of $20,000. This would spell bearish future sentiment for the price of Bitcoin.
Simply put, your job is to predict whether the Bitcoin futures contract will close at a price higher or lower than $20,000 in three months. If you speculate correctly, you make a profit. If you don't, you will make a financial loss.
It is important to note that you are obligated to buy or sell the underlying asset when the futures contract expires. However, you can usually cash out your futures before they expire, allowing for more flexible, low-risk trading. You might want to secure your win early. Or maybe you want to cut your losses on a trade that you think will almost certainly result in larger losses at the time of expiry.
One of the standout benefits of Bitcoin futures is the use of leverage. Leverage is simply borrowing to increase capital efficiency, which allows for greater profit (or loss).
At 10x leverage, you have access to 10 times your own capital to invest in Bitcoin futures. If you have, for example, $100 in an exchange account, you can open a position worth $1,000 in BTC.
In the same way that leverage can increase a trader's profits, it can also increase incurred losses if the bitcoin price does not move in the desired direction. Therefore, it is advised that you take caution when using leverage. For beginning traders, the most appropriate risk is to use a conservative leverage of 2x or 5x.
When someone buys a Bitcoin futures contract and holds it until the expiration date, it will be settled under the terms of the contract. The buyer will receive the agreed amount of BTC (physical settlement) or the cash equivalent, at the agreed price.
However, the flexibility of Bitcoin futures trading allows for several ways to trade the contracts. In addition to settlement at the end of the contract, the buyer has other options. A buyer can choose to renew the contract until another date in the future, or they can simply exit the position before the specified date. A third option is to renew the contract to be settled at a date after the original expiration date.
Many financial experts believe that the adoption of Bitcoin Futures into the traditional trading market will boost the mass adoption of cryptocurrencies as a whole. The most significant advantage of Bitcoin futures contracts is that they offer exposure to Bitcoin in a regulated environment. For investors, the cryptocurrency market is not sufficiently regulated. In the case of Bitcoin futures, there are specific regulations, which are not seen in the spot markets for that cryptocurrency.
This suggests that demand will increase and this will positively impact the price and market cap of Bitcoin in the long run.
Bitcoin's appearance as a traditional financial instrument means that regulators recognize it as an investment object - and this is good news. The US market is one of the most regulated and largest markets in the world and the adoption of Bitcoin futures by this market only says it is a matter of time before other countries follow suit. Moreover, in jurisdictions where trading of cryptocurrencies is prohibited, futures allow traders to speculate on the price of the underlying digital assets without trading the assets themselves. All these point to a bull sentiment for the price of Bitcoin.
On the other hand, whales and large-volume traders similarly have the opportunity to open short positions which are speculated to put bearish pressure on the price of Bitcoin itself. Since Bitcoin Futures traders do not require a Bitcoin wallet to trade futures especially if they are using popular exchanges such as CME, large market participants are less likely to hesitate before entering into a contract. However, Tim McCourt, the top manager at CME believes that trading Bitcoin Futures barely has any impact on the price of Bitcoin as this market only represents a small fraction of the whole.
It is safe to say while Bitcoin Futures do not have a direct impact on the price of BTC, they do weigh on and have an impact on the market sentiment. There is also an opinion that Bitcoin futures help to reduce the volatility of its price.
Nonetheless, integrating the cryptocurrency market with the traditional market has the potential to contribute to the widespread adoption of these crypto assets and, consequently, their long-term growth.
It has already been mentioned that the use of high leverage increases the risks of trading Bitcoin futures. One of the recommended techniques as part of futures contract risk management is the use of stop-loss orders, which automatically exit positions when they reach a certain percentage of losses.
It is advisable to set a hard limit when starting to invest in leveraged futures contracts. For example, limit investments between 1% and 5% of your capital when you want to open a position in futures. Some exchanges offer practice platforms to learn more about futures trading in real-time, without the need to risk real money.
Bitcoin futures contracts are regulated by the Commodity Futures Trading Commission (CFTC) in the United States. This is why many see futures as a safe way to invest in Bitcoin. However, Bitcoin futures are not for everyone. This is because they're complex financial instruments that require an understanding of not just Bitcoin — but of the futures market itself.
However, if you are willing to put in the work and take your trading beyond traditional cryptocurrency trading, then futures might be worth considering.
Bitcoin futures are a type of financial contract that allows investors to speculate on the future price of Bitcoin. In a futures contract, a buyer agrees to purchase Bitcoin at a future date and at a predetermined price. This allows investors to hedge against the volatility of Bitcoin's price and potentially profit from price movements.
Trading Bitcoin futures can offer several benefits, including increased liquidity, and leverage, amplifying one’s potential profit, and the ability to go short or long on Bitcoin.
What will the futures market do to Bitcoin?
The futures market does not have a direct clear effect on the market, but rather a complex multifaceted hold on it. On one hand, futures allow investors exposure to Bitcoin without having to hold the actual crypto. This provides liquidity and makes it harder for solo traders to manipulate the market. On the other hand, Bitcoin futures could a disconnect between the price of Bitcoin futures contracts and the price of the underlying crypto, which can make it more difficult to accurately value Bitcoin.
Regardless of the effect, there is general consensus that BTC futures encourage institutional investors and Bitcoin traction.