Introduction to Bitcoin Futures

Today the Chicago Board Options Exchange (CBOE - www.cboe.com) will start trading futures contracts on Bitcoin. Next week the Chicago Mercentile Exchange (CME - www.cmegroup.com) will also start trading their own futures contracts. Although I mainly teach statistics/data science at the moment, I have previously taught finance courses - including classes on derivatives, so I thought I would give a bit of a primer on futures contracts (although this was before the time of cryptocurrencies which have some new challenges attached to them).

What is a futures contract?

A futures contract is an exchange traded derivative (which is a financial instrument linked to an underlying asset). The futures contract has a buyer and a seller (which are also known as going long and going short). The buyer of the contract agrees to buy the underlying asset from the seller for the "futures price" at a time in the future that is stated in the contract. Unlike an options contract, there is no "if they would like to" in a futures contract. The buyer is betting on the market (spot) price going up and the seller is betting on it going down (i.e. there will be a winner and a loser from this contract).  Since the futures contract is a tradeable derivative, I can sell my position in the contract to someone else. The cost of the contract depends on the difference between the current (spot) price and the futures price of the contract. 

There are futures contracts on stocks, indices/markets, currency, and a range of tradeable commodities. Futures contracts can be used for risk management/hedging.  For example if you are an importer with a big contract in a particular currency, you could go short a futures contract in that currency to manage your foreign exchange risk. However, they can also be used to speculate in markets without having to actually purchase the stocks/currency/commodities. 

Although you have a contract to buy/sell the underlying asset, most transactions are finalised through cash settlement (whoever is down paying the cash difference to whoever is up). 

The bitcoin futures contracts will allow you to speculate (or hedge) on the price change in bitcoin without actually holding any. 

Some Other Terms

Margins - When you enter into a futures contract you are required to have an "initial margin" which is an amount of money in your account to cover losses if the price of the underlying asset fluctuates out of your favour. There will be a "maintenance margin" which is the lowest amount your account can drop to before the market initiates a "margin call" where you need to deposit more money. This is how the exchange ensures that your losses will be covered. 

Price Limits - Some contracts have price limits. In the event of high price fluctuations this can trigger different things such as a halt to trading. It looks like there will be 20% price limits on bitcoin futures, that is, if the price of bitcoin fluctuates by more than 20% they will halt trading on the contracts. 

Settlement - The transfer of cash based on the profit or loss of your contract. 

Bitcoin Futures Specifics

The CBOE and CME contracts have a number of differences. 

• The contract size for CBOE is one Bitcoin whereas the CME contract size is five bitcoins. This means that smaller investors will be more likely to use the CBOE. 
• The CME uses a price index based on various exchanges. The CBOE is using the price at 4pm ET on the Gemini Exchange. 
• CBOE is requiring (at the time of writing this) a 44% initial margin vs 35% for CME. 
• The exchanges only operate on weekdays. This could lead to some interesting Monday effects

Some Final Thoughts

There is no precedent on this and it is going to be really interesting to see what happens. The underlying asset (bitcoin) is highly variable and not easily valued. Given the negative comments that have come out of the big banks and finance firms, I am interested to see whether this starts to legitimise cryptocurrency, or at the very least see some more involvement from the sector. I think the barrier to entry for trading the futures contracts (especially the CME ones) is higher than the currency itself so we will see more companies and higher tier investors, especially at first. Traditionally futures contracts have been seen as a mechanism for price discovery and a reduction in the variability of the price of the underlying asset. I don't believe that this will happen here (at least not in the first year). 

If you are predicting a bitcoin crash though, you now have a tool to bet on it. 

Thanks for reading. I hope you found this interesting.