Bitcoin Futures Contracts Explained
There are many ways to trade or invest in bitcoin. In this post, I’ll explain how bitcoin futures contracts work.
What are futures contracts?
A futures contract is essentially a forward contract that can be bought or sold on an exchange.
A forward contract is an agreement to buy or sell X amount of an asset at price X in the future. This allows people to “lock in” a buy or sell price of an asset in the future to protect them from the risk of an unfavourable price change. The example in the box below explains this concept in more detail:
Forward Contracts: the wheat farmer and the baker
A wheat farmer sells wheat to a baker at the end of the wheat harvesting season. The baker uses the wheat to make bread. The price of wheat at the end of the harvest season affects the wheat farmer and the baker differently:
- If wheat is cheap in the future, the farmer loses out when he sells it to the baker. The baker wins because he can buy the wheat cheaply from the farmer.
- If wheat is expensive in the future, the farmer makes more money when he sells it to the baker. The baker loses out because he has to buy wheat at the higher price.
In this case, wheat is the underlying commodity. Its price fluctuates up and down all the time, yet the bakers’ bread stays the same price all year. This is made possible through forward contracts.
Say the baker wants to buy 10 bushels of wheat from the farmer in two months time. He could enter into a forward contract with the farmer to buy those 10 bushels of wheat at a price they both think is fair. Now the farmer and the baker have “locked in” the price of their future business deal.
So that’s the basic idea behind a forward contract—the baker and the farmer are hedging price risk.
Bitcoin futures: the basics
Bitcoin futures allow traders to speculate on the future price of bitcoin without ever having to buy or sell any bitcoin. This means they don’t have to worry about keeping their bitcoin safe through cold storage.
Bitcoin futures contracts are traded on an exchange (more on this later). Through the exchange, people buy or sell futures contracts just like they would a stock, crypto-coin, bond, ETF, option and so on.
With everyone buying or selling bitcoin futures contracts, the contract prices shift up or down—just like like anything else.
There are usually two types of traders in a futures contract:
- Hedgers: we have already covered these in the example above with the wheat farmer and the baker.
- Speculators: those who speculate on what the price of the asset will be at some future date.
With bitcoin, an example of a hedger could be Jimmy the bitcoin miner who mines bitcoin for a living. Jimmy may want to lock in a future bitcoin price to stabilise his bitcoin mining income in case the price of bitcoin falls in the future.
While hedgers like Jimmy do exist, it’s safe to say that today the majority of bitcoin futures contracts are bought and sold by speculators. You’ll soon find out why this is actually a good thing.
There are two types of positions people take on bitcoin futures contracts:
- Long futures contract: agreement to buy bitcoin in the future. They win if the price of bitcoin is higher than the futures price at contract expiration—they can settle their futures contracts by buying bitcoin below the current (“spot”) bitcoin price.
- Short futures contract: agreement to sell bitcoin in the future. They win if the price of bitcoin is lower than the futures price at contract expiration—they can settle their futures contracts by selling bitcoin above the bitcoin spot price.
Side note: remember, we don’t need to buy or sell bitcoin to participate in the bitcoin futures market. This is because bitcoin futures contracts are “cash settled”. This means that only the difference is paid or received when the contracts expire. More on this in the example below.
Another side note: being able to short bitcoin through futures contracts would have worked well in the recent bitcoin bear market. However, you would have been crushed if you tried to do that in a bull run!
The next example dives deeper into the mechanics of bitcoin futures…
Example: the inner workings of bitcoin futures
Assume we have two bitcoin futures traders:
- Jane, who is bullish on bitcoin—she thinks the price will go up in future.
- Jeff, who is bearish—he thinks the price will go down.
Futures contract phase 1: open futures positions
Jane and Jeff each want to speculate on the future price of bitcoin in 1 month’s time—without having to own any bitcoin. The below diagram shows how they do this with futures contracts:
When Jane and Jeff enter into their futures contract positions, the price of each contract is $5,000. Since Jane and Jeff are both high rollers, they open 10 contracts each (we will talk about leverage soon, but for now, it’s best we ignore it).
The total value of the 10 contracts is $50,000 (10 x $5,000).
Futures contract phase 1: settlement
Assume at settlement (1-month later) the spot price of bitcoin is $10,000. The current market value of the 10 bitcoin contracts has therefore increased from $50,000 to $100,000 (10 contracts x $10,000). At this point, Jane and Jeff must each deliver on their respective contract obligations at the futures settlement price of $10,000:
Jeff initially sold 10 contracts for $50,000, thinking the futures price would go down. Sadly for Jeff, the futures price went up. Jeff must now deliver on his obligation to sell 10 bitcoins for $50,000 even though they are actually worth $100,000.
Therefore, Jeff has lost $50,000.
Jane first bought 10 contracts for $50,000, thinking the futures price would go up. Fortunately for Jane, that is exactly what happened. Jane can now buy 10 bitcoins for $50,000—even though they are now worth $100,000.
Jane has won $50,000.
Side note: again, bitcoin futures are cash settled on the exchange, so we don’t need to buy or sell bitcoin to participate in the bitcoin futures market. Only the cash difference is paid or received. So in this case, Jeff would owe $50,000 and Jane would receive $50,000 on their respective futures positions at settlement.
The best way to explain leverage is through the example of buying a house. Below is a comparison between buying a $50,000 house without leverage vs. with leverage (the $50,000 house price is just for illustration!)
- Buy house worth $50,000. Pay $50,000 of own money.
- Sell house for $100,000.
- Earn $50,000 profit (100%).
- Buy house worth $50,000 but only deposit $25,000. Borrow remaining $25,000 from the bank.
- Sell house for $100,000.
- Pay back $25,000 loan to the bank.
- Profit $75,000 on $25,000 deposit (200%).
Side note: if the house price halved to $25,000, you would still need to pay the bank back $25,000. You would also lose $25,000 on the sale. Therefore, you would have lost double.
Leverage and bitcoin futures:
With each exchange, the minimum contract size is 5 bitcoins.
With leverage, futures traders need only put down an initial margin (like a deposit) to open a relatively large futures contract position. This magnifies both gains and losses.
To explain this we can go back to our earlier example with Jane and Jeff. Assume they each needed to only put down an initial margin of 50% ($25,000 for 10 contracts valued at $50,000). The diagram below shows how Jane’s gain and Jeff’s loss are each magnified with leverage:
Clearly, Jeff has a large obligation to pay the exchange to settle his contract. To make sure Jeff pays up, the exchange gradually increases Jeff’s margin deposit as the price moves against him.
Bitcoin futures strategies
A bitcoin futures contract has its own price, which is based on the collective speculation of what the price of bitcoin will be when that futures contract expires.
If people are speculating on the future price of bitcoin, then it stands to reason that the futures price could be very different from the current spot price of bitcoin. It also stands to reason that as the futures contract gets closer to its expiration date, the futures price will get closer to the spot price. Here’s an easy way to think of this:
- If you had to guess (speculate) what the price of bitcoin would be in one month’s time, you wouldn’t have a clue.
- But if you had to guess what the price of bitcoin would be in 10 seconds’ time, you would be confident that it would be close to the current spot price.
Now imagine lots of bitcoin futures speculators are doing the same thing. What you have is this relationship:
As the futures contract gets closer to expiration, the bitcoin futures contract price gets closer to the expected future bitcoin spot price.
The above relationship comes with one very important caveat: the futures price does not move towards the spot price in a straight line. More on this later.
Contango and Backwardation
The words ‘contango’ and ‘backwardation’ refer to the relationship between the current (spot) price of an asset and its futures price.
- Contango: the futures price is above the spot price.
- Backwardation: the futures price is below the spot price.
If bitcoin futures are in contango, then as the contract gets closer to expiration, the futures price will get lower relative to the expected future bitcoin spot price. The opposite is true for backwardation…
The above diagram gives us a clue on how we could potentially earn investment returns through bitcoin futures—this would depend on whether the futures price is trading above (contango) or below (backwardation) the current bitcoin spot price.
Here are two potential strategies:
If the futures market is in contango, the expected future spot price is below the forward price. As time goes on, it is expected that these two prices will converge, with the futures price getting lower relative to the spot price.
If you expect the futures price to go down relative to the spot price, you can short the futures contracts and earn the ‘spread’ between the two prices on each contract.
The opposite is true for backwardation, where you expect the futures price to increase relative to the expected future spot price. Therefore, you would go long the futures contracts, and sell them prior to expiration for a profit.
Side note: earlier I said that bitcoin futures markets are mostly made up of speculators, and how this could actually be a good thing for traders. Because the futures market is so speculative, the differences between the futures price and the expected future spot can be quite large. This can create opportunities for profits through either of the above strategies.
Another very important side note: remember the contango and backwardation convergences do not occur in a straight line. This means that if the trade goes against you on a particular day you could get ‘margin called’ by the exchange.
Cash and Carry
The cash and carry strategy is a common way to take advantage of the price differences between the bitcoin spot price and the futures price.
For example, assume that today the bitcoin futures price is trading 20% higher than the bitcoin spot price. The market is in contango.
The cash and carry strategy can be broken down as follows:
- Cash: sell the ‘cash settled’ futures contract, which you expect to go down in price.
- Carry: buy (or ‘carry’) the actual bitcoin.
Remember, a short futures contract is an obligation to sell bitcoin at a specific price in the future. Since you already bought the bitcoin, you can sell it at the future spot price on expiration to deliver on your contract.
When the futures contract settles, the spot price and the futures price will have converged. So you would have made 20% on the short futures contract without taking on too much risk.
With backwardation, the opposite strategy could work:
- Cash: buy the ‘cash settled’ futures contract, which you expect to go up in price.
- Carry: sell short the actual bitcoin.
That’s the basics of bitcoin futures. They offer a way to hedge the price risk of bitcoin but are more suited to institutional investors given the minimum trade size of 5 bitcoins. As always, none of this is investment advice. Bitcoin futures are very risky investments!
Jonathan Hobbs, CFA, is an author, entrepreneur and financial blogger. He invests in stocks, mutual funds, startup companies, gold and cryptocurrencies. He believes strongly that nobody can predict the future of financial markets, so he prefers to simplify his approach to investing with basic investment rules and strategies that work well over time.