The CME (Chicago Mercantile Exchange) has decided to start to trade BTC futures. That's all well and good, but what is it?
(Personal note: I haven't blogged in awhile because I've been under the weather. Sorry about that. But rest assured, some interesting stuff is in the offing. If you are thanks for reading!)
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Obviously, there's going to be a lot of speculation. You'll read that the price of BTC is going to soar because of institutional backing. You'll also read that the traditional financial community is amped to short BTC and given a vehicle to do so they're going to "sell" it into oblivion. However, if you've been trading BTC on the cash exchanges (e.g. Coinbase or Bittrex) a futures contract might seem like a strange way to approach BTC. This article will attempt to help you out and explain some of the in's and out's in a down and dirty fashion if you're new to futures.
Quick vocabulary:
Spot price: current price of underlying (approximate price right now that you could buy BTC (the underlying) if you went to Coinbase for example)
Futures price: price of underlying in contract cycle month (price in futures month)
Contract month: month with settlement date of futures contract at that price (when the deals are settled and the money changes hands if you should so want that)
Sell order: initiate a short position (think the underlying's price is going to go down)
Buy order: initiate a long position (think the underlying's price is going to up)
Futures are NOT like owning a BTC outright, safe in your digital wallet. Each futures contract is a deal struck between two parties to buy or sell an underlying at a future date. So, in our terms, if today, November 8th, 2017, you and I entered into a contract for me to buy BTC at $8000 from you in January 2018 then if BTC's price was actually less than $8000 in January than you would make the difference between the spot price (current traded price of underlying) and the contract price. To explain, I'd have to sell the BTC futures contract at $8000 to you, which in theory you would have bought the BTC for less to sell it to me on the open market. If it is more than $8000 than I would make the difference because I'd be buying it for less from you than the spot price at the settlement date, and in theory I could turn around and sell it for its current or spot price making that difference.
(I know, it's a little confusing. Please comment and ask questions. I'd be more than happy to help.)
However, futures are dynamic instruments and are bets/ideas on what the price of an underlying will be at the settlement date in the future. It is worth noting that you can enter and exit positions as you see fit before the contract settlement date. Also, depending on the contract specifications they are either cash settled or physically settled. One big thing to remember is that a futures contract is just a contract between two entities to engage in an exchange at a predetermined date for a predetermined price. As such, it is NOT the same as owning a BTC now.
To better explain how settlement can function, coffee futures contracts are physically-settled. If you are a trader and let a coffees futures contract go to its settlement date you'll be responsible for the payment and shipment of that contract of coffee - about a train car's worth of unrefined coffee at the delivery point if you hold only one contract. However, because of leveraging and span margining with your brokerage it is highly unlikely that without actually having the capital to support a delivery of coffee that your brokerage would allow you to let the contract go to settlement. (More on margining in future posts if I get requests.)
On the other hand, BTC is a cash-settled indexed future. What the CME has done is track the price of BTC and created a framework by which to determine what is the current spot price, which is the mean of several online exchanges taken at a point in time during the day (thus, indexed). Once they determined that framework for the spot price then they went about forming the futures contract. Here are the specs:
- 1 Futures contract = 5 BTC.
- Minimum tick $5/BTC, or $25/contract.
- Market open from Sunday at 1700 to Friday at 1600.
- Daily price movement limit of 20% (either up or down).
- Spot position limit of 1000 contracts.
- Settlement price based off of "Bitcoin reference rate" USD/BTC as of 1600 London time.
So, a BTC's future contract has less to do with delivery (you get your BTCs if you let the contract settle) as it has to do with speculation on the price at the future date, i.e. you get the difference in terms of price from the spot price to the futures contract in cash.
Great! But how do I take part?
That's a great question. Knowing some of the background, as I attempted to explain is useful insomuch as you'll sound smarter at dinner parties, but that's not really how one trades and makes money. Here's the deal with futures in the simplest form after having opened an account with a brokerage of your choice, learning about margining, and reading more. This article is just about some mechanics.
You decide that the price of BTC is going to drop in the next 3 months. You offer to sell a BTC futures (futs) at some price level in the futs contract 3 months from now. Another entity who thinks it's going to climb in price purchases your contract. Neither of you own BTCs at the time of the sale/buy on the futs contract. Time passes and the price in the settlement month goes up and down. Finally the price soars higher. Your account is showing a lot of red. You decide to buy back your original "sell" contract to get out of the trade because you think the price is going to continue to climb. You buy the contract back at the higher price and lose the difference from where you entered the trade and where you got out. Your new exchange is probably not with the same person or entity either. If you decide to buy a contract the inverse is true, if the price goes up you can sell it for more.
That's the interesting thing about futures. You can sell before you buy. The easiest way to explain it is that given a settlement month (which is the specific price you need to watch because it will be different from the spot price) if you think the price is going to go down initiate a sell order. If you think the price is going to go up initiate a buy order. It's as simple as that. Just make sure that you watch the price of the contract month - not the spot price - as the two typically are different.
A thing to remember at the moment is that the BTC contract as put together by the CME is a big contract for most people's accounts. If you own a stock its price can change by a penny. In other words, stocks tick in $.01, which is also the MINIMUM tick for most stocks. This BTC futs contract ticks in $25 as its MINIMUM tick. So, every step up or down in the price is $25. That means that if the price gets moving quickly in one direction or another then there is the risk to lose a lot of money - or make a lot of money. But a lot depends on your account size and your appetite for risk.
Another thing to remember is that futures were originally intended to be a product to hedge current positions. There's a world of ways to use futures, but as the individual, retail trader these are the down and dirty pieces of futs. I could write volumes on it.
Anyway, thanks for reading and I hoped this helped. As always please make comments and post questions. Take care!
We're all gonna make it!
Minderbinder
Sources:
Business Insider. We just got a glimpse of how bitcoin futures work.
Investopedia.com. How are commodity prices different from futures prices.
[Disclaimer: All the opinions expressed in this article are my own and are in no way meant to be construed as investment advice. Please exercise your own judgement in any investment or money management ideas that you happen to undertake. All images come from either personal files or websites that allow free images and each has an inline citation for reference. Good luck out there!]
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