Cryptocurrency ‘futures’ is a concept in banking and trading that’s covertly making headways. Very few are aware of what futures are and what they do, let alone Bitcoin futures. So this article will provide a thorough explanation of what futures contracts are and how you can trade the Bitcoin variant.
As an introduction to this topic, we must first define what Bitcoin is as a whole. At the risk of sounding repetitive, defining the famous cryptocurrency will aid in the overall topic of futures. By providing context, we will be properly prepared for what’s to come.
Currencies & Contracts
Bitcoin is the world’s most well known digital currency whose creation dates back to January of 2009. It’s a cryptocurrency that ensures lower transaction fees than that of traditional online payment methods. A decentralized consensus mechanism ensures its operation, unlike currencies which are primarily government-issued and centrally controlled.
Bitcoin is a digital currency. Like other digital assets, it can represent an erratic and risky investment. By contributing your time and money to them, you are basically putting a lot on the line. Many traders try to mitigate the risk by purchasing an asset whenever the price drops. Alternatively, they sell it whenever the price goes up. As promising as this tactic appears to be, there is a prominent downside to it. Very often, the money remains “on the table” after you leave the market.
Should the price keep rising after you sell it, you’re essentially missing out on the profits you could earn if your position was still open. A crucial benefit concerning futures trading is that you’re able to hedge existing spot positions without any additional crypto. This effectively allows you to be flexible, agile, and ready for any market environment.
Fluctuations in the underlying currency’s value between your time of trading for a futures contract and your liquidation attempt will affect the value of your futures contract. Furthermore, it impacts the potential profit or losses that are in relation to it. Overall, investors need to be very cautious and monitor any and all investments they make.
Cryptocurrency futures give you the ability to maximize your returns. This is possible by way of utilizing leverage to multiply your profits and applying trading strategies. You can use futures to estimate the direction of the market, thus minimizing potential risks. All this is achievable while holding less crypto than on a spot exchange.
What exactly is it?
With the foundation in place, you might be wondering what exactly a futures contract is. Likewise, you’re probably curious about the subject of actually trading them.
A futures contract is a legal agreement for purchasing or selling a specific commodity or asset at a set price and time. Futures contracts are made for quality and quantity in order to facilitate trading on futures exchanges. The buyer of a futures contract is, in essence, taking on a heavy obligation. That being they have to buy the underlying asset as soon as the futures contract expires. The sellers of the contract have a crucial obligation of their own, which is providing the underlying asset upon expiration.
There are two categories of market participants that typically use futures contracts: hedgers and speculators. The producers and buyers of an underlying asset hedge or ensure the price that the commodity sells for. Portfolio managers and traders might also make a bet on price movements of an underlying asset using futures.
Investopedia editor, James Chen, provides an example of a futures contract by using an oil producer scenario:
“An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.”
Something important to note is that futures are available on a number of different assets. There are an array of futures contracts on stock exchange indexes, commodities, and currencies.
There is a mathematical model that is useful for pricing futures. It takes the following factors into account:
- The current spot price (the price at which an asset can be sold for immediate delivery)
- The risk-free rate of return (the theoretical rate of return of an investment with no risk)
- Time of maturity
- The storage costs
- Dividends (the distribution of a reward from a portion of a company’s earnings that its shareholders receive)
- Dividends yields (the ratio of a company’s annual dividend in comparison to its share price)
- Convenience yields (the benefit of holding an underlying product or physical good, rather than the derivative security and contract)
Let’s assume, for example, that a one-year oil futures contract is worth $78 per barrel. By entering in this contract, the producer has to deliver one million barrels of oil in one year. Consequently, it’s a guarantee that they will receive $78 million. The $78 per barrel price is obtained regardless of wherever the spot market prices currently are.
Contracts, as a whole, are standardized. For instance, a single oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. Thus, if someone wants to lock in a price on 100,000 barrels, they have to buy/sell 100 contracts. In order to lock in a price of 1 million barrels, they need to buy/sell 1,000 contracts.
When it comes to delivering or receiving the underlying asset, both retail traders and portfolio managers have absolutely no interest. The standard retail trader has very little need to receive up to 1,000 barrels of oil. However, they may have an interest in obtaining a profit on the price moves of oil.
Futures contracts are something that you can trade for profit, just so long as the trade closes before expiration. The date of expiration for a majority of futures contracts is usually the third Friday of every month. With that in mind, it’s important to note that contracts do vary. It’s a good idea to check the contract specifications of any and all contracts before you begin trading them.
Let’s set up another scenario to properly explain this. It’s January and April contracts are trading at a price of $55. The trader is of the belief that the price of oil will increase before the contract expires in April. Because of this, they can potentially purchase the contract at $55. This effectively grants them control of 1,000 oil barrels.
There is, however, no requirement for them to pay $55,000 ($55 x 1,000) for this particular privilege. Instead, the broker needs an ‘initial margin’ payment, usually of a few thousand dollars per contract.
For contextual purposes, an initial margin means the percentage of the purchase price of a security or basket of securities. An account holder must pay for this by way of using available cash in the margin account. Alternatively, it can be with additions to cash within the margin account or any other marginable securities. To learn more about margin, read one of my previous articles, “What is Margin Trading?”
As the price of the futures contract moves, the profit or loss of the position wavers in the account. Should the price get too big, the broker will ask the trader to deposit more money to cover the loss. This is a ‘minimum margin’, which is the minimum amount of equity that has to be kept at bay in a margin account. The New York Stock Exchange (NYSE) and FINRA demand that investors keep at least 25% of their securities’ total value. Specifically, their securities residing within a margin account.
The reveal of the total profit or loss of the trades occurs when the trade concludes. In this particular case, assuming the buyer sells the contract at $60, they will make $5,000 ([$60 – $55] x 1,000). However, should the price drop to $50 and the position closes out here, then they will lose $5,000.
Bitcoin futures trading is becoming readily available on various broker platforms. One of these is TD Ameritrade. So, with the knowledge of what futures actually are, how do we go about trading the Bitcoin variant at TD Ameritrade?
First and foremost, you need to open an account with this broker and indicate your desire to actively trade. There are specific qualifications and permissions that are a requirement on your account for CME Group Bitcoin futures trading. This includes:
- Enabling margin
- Approval of Tier 2 spread option
- Enabling of advanced features
- Approval of futures trading
- Account minimum of $25,000
As soon as you’re able to trade futures, you will still need access to BTC. This will allow you to add Bitcoin trading to your account. Keep in mind that the TD Ameritrade margin requirement for Bitcoin futures products is 1.5 times higher than exchange margin requirements. Moreover, it is a frequent subject to change without any notice.
The funds in your account must be clear before they can partake in trading futures contracts. This, of course, includes Bitcoin futures. ACH and Express Funding methods typically require roughly 4 business days in order for the deposits to clear. Conversely, the clearing of a wire transfer will take place on the same business day.
Futures products carry unique and – in some cases – incredibly significant risks. However, they can potentially provide a more stable environment with steady regulations. This environment could provide some exposure to Bitcoin as something of a commodity as well. There are certain factors you should take into consideration on whether trading in Bitcoin futures is right for you. They are the following:
- Your experiences
- Personal objectives
- Your financial resources
- Any other circumstances that may be relevant to this decision
Kraken is another platform that provides futures trading. Along with Bitcoin futures, they also offer futures belonging to Ethereum, Litecoin, Ripple, and Bitcoin Cash. They provide pairs with these currencies, which is essentially the quotation of two different currencies. The first currency of a pair is the ‘base currency’, and the second currency is the ‘quote currency.’
Each pairs’ leverage is up to 50x and the time frames are typically monthly, perpetual, and quarterly. With the exception of XRP/BTC, the contract size is 1 USD; XPR/BTC’s contract size is 1 XRP. The types are primarily Inverse, with the exception once again being XPR/BTC, which is a Vanilla type.
- BTC/USD – Collateral is BTC
- ETH/USD – Collateral is ETH
- LTC/USD – Collateral is LTC
- BCH/USD – Collateral is BCH
- XRP/USD – Collateral XPR
- XRP/BTC – Collateral BTC
According to their website:
“Futures are extremely capital efficient, meaning that less money is required to open positions than if you were spot trading (1x) or margin trading (3-5x). This means if you have 10 Bitcoin and are scared of price decline, you have to trust 100% of your money to spot exchange to sell, or 20% of your money on margin exchange. With 50x futures, you trust as low as 2% of your money on exchange.
Using collateral as low as 2% of the notional amount, crypto futures allow you to take positions with up to 50x leverage — giving you flexibility to position yourself in the market while maintaining low exchange risk.”
A quick disclaimer
There is an additional point that you should take note of. Virtual currency is, above all else, a digital representation of value that primarily functions as an exchange medium. Alternatively, it can also serve as a unit of account or a store of value. Be that as it may, it does not possess any kind of legal tender status.
You can exchange virtual currencies for U.S. dollars or most other currencies from around the world. Nevertheless, they don’t have backing or support from any government or central bank. Their value derives from market forces of supply and demand and they are incredibly volatile; more so than fiat currencies. Profits and losses in relation to this erratic nature amplify considerably in further contracts of the margin variety.