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Bitcoin Futures And How They Work

logic behind bitcoin futures

May 10, 2021 | 

444 Views | 

JOHN K MWANIKI | 

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Although the idea of futures has been there in the financial market, it was introduced in the crypto space a few years ago. Bitcoin futures came into existence in 2017 but have gotten increasingly popular in a few years.

What are bitcoin futures?

Bitcoin futures are derivative products traded in the form of contracts. Basically, bitcoin futures involve a commitment between two parties to buy or sell bitcoin at a specified price on a predetermined date in the future. Simply put, futures are a bet. They allow bitcoin users to wager upon the future value of bitcoin. When the agreement expires, the parties have to exchange the bitcoin at the agreed price regardless of the real market value of the bitcoin.

How do bitcoin futures work?

In bitcoin futures, you can hold a short position or a long position. By holding a long position, you agree to buy the bitcoins when the contract date expires. On the other hand, by agreeing to hold a short position, you agree to sell the bitcoins when the contract date expires. After the parties settle, the contract closes.

Hedging

Bitcoin futures enable you to hedge a position if you think that the market trend might move against you in the meantime. Here, you only have to put up a small margin upfront to hedge your investment. You might be wondering how someone would be interested in hedging with bitcoin value. 

The most interest in bitcoin futures for hedging is mostly from bitcoin miners who invest much capital in production, mining blocks on the blockchain. Since bitcoin price fluctuates heavily, the dollar value for a block can be very unpredictable, which presents a risk for long-term miners who have fixed mining costs such as high electricity bills, high computing equipment, cooling, maintenance costs, etc. They use hedging in bitcoin futures to protect themselves from risks whereby their running costs surpass their income for a particular period.

Calculated speculation is necessary because the price of bitcoin is very volatile. It may be at $5000 today and $10,000 in three months. In such cases, investors and traders use futures contracts to hedge their bets.

Trade on margin

Some bitcoin futures markets offer leverage which involves borrowing capital to facilitate the contracts. Margin enables you to trade using more than you hold in your brokerage account. For instance, if a bitcoin futures broker allows you to trade with a 10% margin, a $2000 position requires you to have an available account balance of $200.

In other words, leverage in bitcoin futures allows traders to access larger positions without financing the position upfront. Bitcoin investors who trade on margin do not have to attain the total value of the futures contract.

Instead, they use leverage to achieve a futures contract with a comparatively lesser equity stake called initial margin. If the position goes against the trader, they must adhere to the maintenance margin level to keep the position open. If they breach that level, the position is finally liquidated. You must note that the leverage threshold is different from one futures broker to another.

Short selling

Short selling is also another common way of using bitcoin futures contracts. Suppose you wanted to short sell bitcoin. In that case, you would more likely want to use an exchange that supports CFDs (Contracts for Difference). Although you can get platforms that provide low trading commissions on CFDs, the challenge is getting hit by overnight financing costs. Despite the asset class or broker, there is a fee charged on all CFD markets every day to keep the position open. That means that short selling on CFDs is only beneficial in the short term.

But bitcoin futures provide a more cost-effective method of shorting the currency than CFDs. You can maintain the futures contract in an open position for the entire period and pay only the settlement fee.

Trading basics for Bitcoin futures 

Suppose the value of bitcoin is $1000, and you believe that it will increase in value and buy five bitcoin futures contracts. That brings the position value to $5000. If you were right and the bitcoin value increases and gets to $2000, you can sell your five futures contract at a value of $10,000, whereby you make a profit of $5000.

In bitcoin shorting, instead of buying, you sell the five futures contracts for $1000 each, totaling a position value of $5000. Following a value drop of $5000, you can repurchase the five futures contracts at $2500, keeping $2500 as profit.

For many traders, this method is more attractive than buying bitcoins outright. When purchasing bitcoins upfront, one significant challenge lies in the somewhat convoluted storage of the bitcoins. But in bitcoin futures trading, that challenge is eliminated because the exchange offers appropriate custody. In most cases, bitcoin futures contracts are cash-settled, and that bypasses the custodial issue. Many traders are more confident in trading derivative cryptos since the trading rules are similar to the traditional financial markets' derivative products.

Bitcoin futures provide you with a capital-efficient way to access bitcoins. The potential loss is already considered, and the collateral dealt with during position entry.

Where you can trade bitcoin futures

You can trade bitcoin features on various platforms, including:

  • Chicago Mercantile Exchange (CME)

  • BitMEX Exchange.

  • Binance Exchange.

  • Coinflex.

  • Kraken Exchange.

  • BitFLyer Exchange.

  • Bakkt.

  • BaseFEX

CONCLUDING THOUGHTS

Bitcoin futures provide an excellent way to profit from the virtual currencies market if you are a savvy trader. The most remarkable thing about bitcoin futures contracts is that you don't have to be technically savvy to handle these kinds of trades. You don't require a wallet or have to protect your wallet addresses. All you need is to develop a strategic trading plan and know how to analyze the market trends to speculate bitcoin prices. If you are a savvy bitcoin trader, you can easily profit via bitcoin futures contracts.

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