Please view our affiliate disclosure. Trading involves risk which may result in the loss of capital. The introduction of Bitcoin Futures to the financial sector has had some significant effects on the market. This scenario is ideal for large scale investment firms and those seeking to avoid investing in unregulated markets, such as cryptocurrencies.
Primarily, Bitcoin Futures function similar to stock or commodities futures.
Simply put, a Future is a legal agreement to trade a commodity at a predetermined price and date. In this way, Futures allow investors to speculate on the future price of any given commodity. Consequently, Futures play a critical role in the financial sector. For example, imagine a gold mining firm and how it might utilize futures to its benefit. The miner continues to unearth precious metals as inventors seek to secure their holdings at the current prices.
To buffer the risk involved in this investment, the miner may decide to agree to sell their precious metals at a predetermined price and date. Kraken Futures Trading Terms via Homepage.
Crypto Futures and Their Impact on Investment - Zerocap
In this way, they can ensure they receive their minimum required ROI. Reversely, an investor would seek to acquire a futures contract for less than what they predict the market value of gold will be at that time. Consequently, this maneuver provides more room for profits on the back end. The scenario could occur where the price drops and the investor is stuck with a future that is over-priced.
This is the situation that occurred shortly after the launch of Bitcoin Futures in late As the latter example shows, it takes an experienced investor to leverage futures properly. Critically, you will need to have a firm understanding of the market cycles and fluctuations if you intend to make a profit trading futures. That being said, there are some undeniable benefits Bitcoin Futures introduce to the sector. In the case of Bitcoin Futures, the advantages are too great to ignore. For one, Bitcoin Futures trade on regulated exchanges. Importantly, these platforms receive regulation directly from the Commodity Futures Trading Commission.
Regulated exchanges are more secure than their crypto alternatives. In the past, investors incurred major losses after the collapse of unregulated crypto exchanges. In one now-infamous instance, the largest crypto exchange at the time, Mt. Gox, collapsed after a hack left the exchange in financial ruins. Sadly, the collapsed exchange cost investors millions. Worst of all, investors had no recourse because the platform was unregulated. Another major advantage of Bitcoin Futures is that they settle in cash.
This makes sense once you realize that no actual Bitcoin trading occurred. In fact, the investor and the exchange never own any Bitcoin during the transaction.
Crypto Futures and Their Impact on Investment
As new 3-month away contracts are launched each month, market makers set an initial price for those contracts and the trading begins. As the trading gains momentum, the demand and supply mechanism takes precedence to determine the price of the futures. All futures contracts derive their value from their respective underlying. In case of bitcoin futures, their prices depend on bitcoin spot prices, and any move in the latter affects the former.
This dependency leads to the prices of the two moving in sync with each other, though there is a difference between the two.
The theoretical formula for calculating the futures price from the spot price is as follows:. The formula is based on the concept of cost of carry. Anyone with money to invest in a futures contract can alternatively invest it in secure bonds to earn the minimum available risk free rate of return. Hence, the formula includes a provision for computing the returns which are at least at par with the risk-free rate over time until the contract expires.
In case of there is no possibility of arbitrage, the futures price will be the sum of spot price and the cost of carry, which is reflected in the formula. With the risk-free rate value of 2. Beyond the theoretical calculations, the bitcoin futures prices in the real world tend to run with wild swings in either direction. Image Courtesy: TradingView. The above graph shows the price of bitcoin in blue spot price , the price of bitcoin futures contract expiring in April in green launched in February , and price of a bitcoin futures contract expiring in May in red launched in March.
A few important observations can be made from the above graph. At times, the price of futures may almost come close to the spot price arrow no. This is due to the relative differences between the blue graph spot price and the green and red graphs future prices at the marked locations. Why do such differences occur? Aren't futures contracts said to closely follow spot prices? While the theoretical formula is good for the ideal case of no arbitrage, it does not account for the real-world perception of volatility and price arbitrage.
This happens because the market participants perceive and include the possible impacts of volatility.
How will futures affect Bitcoin
If there are only 2 days to expiry, the futures price calculation formula will simply tell us that due to only 2 days remaining, the price of bitcoin futures contract will remain very close to bitcoin spot price. However, due to high volatility, its spot price may shoot up or down significantly within hours. Additionally, there may be big events occurring, like a particular country like China announcing a ban on cryptocurrencies, which will change the perception of the market participants for the near term that is reflected in the spot price.
It is possible that futures price closed on Tuesday very near to the spot price, but overnight there was a development that spiked the bitcoin spot prices by 12 percent and hence Wednesday morning futures will open with a wide gap. Unfortunately, the theoretical formula does not account for such instances which have the potential to impact the futures prices drastically. While spot prices can instantly reflect bitcoin-related developments, the perceived volatility and its impact over the remaining days to expiry makes futures pricing a guessing game.
Despite all inconsistencies in the price discovery mechanism and the large variance of volatility impact on futures pricing, futures trading remains a high-stakes game. Nevertheless, bitcoin futures trading continues to draw interest as this volatility and uncertainty also allows for profitable opportunities.
Investing in cryptocurrencies and Initial Coin Offerings "ICOs" is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions.
Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies. Library of Congress.
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