In brief
A futures contract is an agreement that obligates a trader to buy or sell an asset at a specific time, quantity and price.
Bitcoin futures help to bring in additional liquidity to the market and also provide opportunities for arbitrage.
As the trading value of Bitcoin varies, so too will the value of different Bitcoin futures contracts.
Coinbase announced on September 28, 2023 that it plans to launch its regulated perpetual futures contracts on its Coinbase Advanced platform (initially for non-US customers). Why futures? Partly because they offer investors a way of potentially taking advantage of the high volatility of most crypto. Let’s use Bitcoin as an example.
Spot trading—the practice of buying and selling Bitcoin—forces traders to exchange cryptocurrencies at their current prices. But what if there was a way to lock in that price of $4,000, picking up the Bitcoin a couple of months later? So even if Bitcoin’s price hit $12,000, the counterparty would have to deliver the Bitcoin purchase with $4,000.
There is! It’s called a futures contract. A futures contract is an agreement between two traders that obligates a trader to buy or sell an asset at a specific time, quantity and price. For example, you might enter an agreement in mid-March to buy one Bitcoin for $4,000 for August 30. You could also be on the other side of the deal, agreeing to selling a Bitcoin for a fixed price. If you’re a buyer, you want the trading price of Bitcoin to go up, as you will be able to buy the cryptocurrency at below market value, while sellers want the opposite, profiting if Bitcoin were to decrease in price.
Futures contracts and the evolution of asset classes
“Futures are an important part of the evolution of asset classes,” Nick Cowan, CEO of the GSX Group, told Decrypt. “They provide a benchmark—a Fair Value, or FV—of what the future value is, allowing arbitrage and liquidity to enter the market.”
Did you know?
Futures contracts originated with 17th-century Japanese samurai, who were paid in rice but were out most of the year doing whatever it is that 17th-century samurai do. But they wanted to ensure that the rice they were paid in, say, February held its value until August, so they traded contracts that obliged the signee to pay out the equivalent amount of rice in August, regardless of its current value.
The reason why you might trade Bitcoin futures as opposed to just, say, buying lots of Bitcoin worth $4,000 at the time, is that you don’t have to hold them yourself. (Our Japanese samurai analogy is helpful here—the Japanese samurai traded futures contracts so they wouldn’t have to store the rice themselves).
Some crypto exchanges, such as OKEx, have lower trading fees for futures contracts, which means that traders can squeeze a bit more out of their accounts by using futures.
How a trader exits their futures position
Nick Cowan, CEO of the GSX Group, told Decrypt: “BTC futures are a great way to bring in additional liquidity to the market and also provide great crypto arbitrage opportunities.” That’s because futures contracts are generally not held until their expiration date. Instead, they are traded like other assets. As the trading value of Bitcoin varies, so too will the value of different Bitcoin futures contracts.
When entering a futures contract, there are three ways a trader can exit their position: offsetting, rollovers and expiry. Offsetting is the most common, and occurs when a trader creates another futures contract with an equal value and size, making their effective obligations zero as they balance out. Rolling over is done by offsetting a position, but with an expiry date that is further into the future. Expiry is what you’d expect: it’s when a contract reaches its end date and the parties who hold the contract buy or sell at the agreed price.
Futures contracts and hedging
Another trading method for futures is hedging. Hedging is a way to reduce risk, which is useful for traders dealing with the volatility of cryptocurrencies.
Consider a trader who just bought three Bitcoin at a $10,000 a pop:
📈 She believes that the price of Bitcoin will rise by the end of the month, but wants to protect her position in case it goes down.
📅 To protect her position, she can enter a futures contract to sell one Bitcoin for $10,000 at the end of the month.
💰 At the end of the month, if Bitcoin has gone up, she will make a profit by selling the remaining two Bitcoin.
📉 If it goes down, she will lose money, but this will be limited as she can still sell one Bitcoin for $10,000.
Hedging reduces a trader’s overall risk, although it does also limit their potential profits.
The pros and cons of Bitcoin futures
First things first: Bitcoin futures are—by their very definition—speculative investments. In its decade-plus year history, Bitcoin has proven that the only constant is price volatility, and while the famed cryptocurrency might be on a bull run now, there’s no telling what tomorrow might bring for Bitcoin. If you speculate at the wrong time, you could be left stranded with a future asset that just isn’t worth it.
There’s also something to be said for being an experienced investor. To successfully utilize futures, an investor needs to understand market behavior, have enough knowledge to pay attention to reasonable market predictions, and enough sense to discard unfounded claims. Ultimately, Bitcoin futures are speculative, but it is possible to leverage good information on a best effort basis. Doing that, however, is not exactly easy, so one might argue that Bitcoin futures are not very accessible for the average person.
The inverse of this is that Bitcoin futures are a great way of getting ahead of a positive market price. If an investor times it right, there could, at least hypothetically, be major profit to be had by leveraging the Bitcoin Futures market.
Bitcoin futures also—counterintuitively—don’t involve holding any Bitcoin whatsoever. Instead, it simply involves trading Bitcoin at a future, pre-agreed upon date, whatever the price at that time may be. Understanding the market might not be the most accessible task, but you don’t even need an ounce of technology to get involved, not even a Bitcoin wallet.
Cash settlements
Bitcoin futures are settled with cash. Because no active Bitcoin trading takes place in a futures market, agreements are satisfied by trading at future, pre-agreed prices. Another oft-cited advantage of the Bitcoin futures market is that the possibility of settling in cash means that no complex software or technological expertise is really necessary in order to get involved in this arena.
Margin trading
One aspect of Bitcoin futures is margin trading, which essentially means that an investor only requires a percentage of a contract’s total in order to participate.
Leveraging 10-20% of a Bitcoin future means that an investment has both a high potential for profit, but also for a loss.
Bitcoin futures: a note of caution
The world of Bitcoin futures isn’t all fun and games. Taking on a contract is a serious obligation, and if it reaches its expiry date, the trader has a legal obligation to fulfill it.
Futures could lose you a lot of money, as you could be forced to buy Bitcoin way above its current trading price. Cryptocurrencies are one of the most volatile asset classes available; as with all cryptocurrencies, trading Bitcoin is very risky.
Disclaimer
The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment, or other advice.
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Source: https://decrypt.co/resources/what-are-bitcoin-futures-how-do-they-work
