How to Trade Bitcoin Futures Contracts

TL;DR

Bitcoin futures contracts are a derivative product similar to traditional futures contracts. Two parties agree to buy or sell fixed amounts of bitcoin for a specific price on a certain date. Traders use them speculatively, but you can also use them to hedge. Hedging is especially popular with miners who need to cover their operating costs.

Futures are a great way to diversify your portfolio, trade on leverage, and bring some stability to your future income. If you want to explore more advanced strategies with futures, take a look at arbitrage. Cash-and-carry arbitrage and inter-exchange arbitrage offer some lower-risk trading opportunities when executed correctly.

Introduction

Bitcoin futures contracts are an alternative investment opportunity to simply holding coins and tokens. As a more complex product, they require a deeper understanding to trade safely and responsibly. Although they are more challenging to use, futures provide ways to lock in prices with hedging and profit from downturns in the market with shorting.

What Are Bitcoin Futures?

Bitcoin futures are financial derivatives similar to traditional futures contracts. To put it simply, you can agree to buy or sell a fixed amount of BTC for a specific price (the forward price) on a certain date. If you go long (agree to purchase) on a Bitcoin futures contract and the mark price is above the forward price on the expiration date, you will profit. The mark price is an estimated fair value of an asset derived from its spot price and other variables. We’ll cover this in more detail later in the article. 

If the mark price is below the forward price at expiration, you will lose money and the short position profits. A short position occurs when a trader sells an asset they’ve borrowed or own while expecting the price to drop. The trader then purchases the asset at a later date to make a profit. You can settle contracts physically by exchanging the underlying asset or, more popularly, via cash settlements.

Why Do People Use Bitcoin Futures?

One major use case for Bitcoin futures is the opportunity for buyers and sellers to lock in future prices. This process is known as hedging. Futures traditionally have been used as hedging instruments in the commodities markets where producers need stable profits to cover their costs.

Traders also use futures for speculation. Long and short positions allow you to bet on the state of the market. In a bear market, it’s possible to still make money by taking a short position. There are also multiple possibilities for arbitrage as well as sophisticated trading strategies.

Benefits of Trading Bitcoin Futures

Hedging

While hedging may seem to be more useful in physical commodity markets, it does have a use in crypto too. Bitcoin miners have running costs just like farmers, and they rely on fetching a fair price for their products. The hedging process involves using both the futures market and spot market. Let’s see how it works. 

The futures contract

A bitcoin miner can take a short position in a futures contract to protect their BTC holdings. When the futures contract matures, the miner will have to settle with the other party in the agreement.

If the price of Bitcoin in the futures market (mark price) is higher than the contract’s forward price, the miner will have to pay the difference to the other party. If the mark price is lower than the contract’s forward price, the other party taking the long position will pay the difference to the miner.

The spot market

On the day of the futures contract’s maturation, the miner sells their BTC on the spot market. This sale will give them the market price, which should be close to the mark price in the futures market. 

However, the spot market trade will effectively cancel any profits or losses made in the futures market. The two sums together provide the miner the hedged price they wanted. Let’s combine the two steps to illustrate with numbers.

Combining the futures contract and spot trade

A miner shorts a contract for one BTC at $35,000 in three months. If the mark price is $40,000 at the maturation date, they lose $5,000 in the settlement paid to the long position in the contract. At the same time, the miner sells one BTC on the spot market, where the spot price is also $40,000. The miner receives $40,000, which covers his $5,000 loss and leaves them with $35,000, the hedged price.

Leverage and margin

An attractive feature for investors is trading on margin. Margin lets you borrow funds and enter bigger positions than you would normally afford. Bigger positions lead to larger profits as small price movements are magnified. On the downside, your initial capital can be rapidly liquidated if the market moves against your positions.

An exchange displays leverage as a multiplier or percentage. For example, 10x multiplies your capital by 10. So, $5,000 leveraged 10x provides you $50,000 to trade. When you trade using leverage, your initial capital covers your losses and is known as your margin. Let’s look at an example:

You purchase two quarterly Bitcoin futures contracts at $30,000 each. Your exchange has let you trade this with 20x leverage, meaning you provide only $3,000. This $3,000 acts as your margin, and the exchange will take your losses from this. If you lose more than $3,000, your position will be liquidated. You can calculate the margin percentage by dividing 100 by the leverage multiple. 10% is 10X, 5% is 20X, 1% is 100X. This percentage tells you how much the price can fall from your contract’s price before liquidation.

Portfolio diversification

With Bitcoin futures, you can further diversify your portfolio and employ new trading strategies.  It’s recommended that you create a well-balanced portfolio across different coins and products. Futures are compelling for the various trading strategies they offer you instead of just HODLing. There are also lower-risk arbitrage strategies with smaller profit margins that can reduce your portfolio’s overall risk. We’ll discuss these strategies further a bit later on.

Bitcoin Futures Arbitrage Strategies

We’ve covered the basics of long and short trading, but that’s not all you can do. Futures contracts have a long history of arbitrage strategies similar to forex markets. Traders use these techniques in traditional markets, and they are also suitable for crypto.

Inter-exchange arbitrage

When different cryptocurrency exchanges have differently priced futures contracts, there is an arbitration opportunity. By purchasing a contract on the cheaper exchange and selling another on the more expensive, you can profit from the difference.

For example, imagine that a BTCUSD Quarterly contract is $20 cheaper on one exchange than on another. By buying a contract on one exchange and selling it on the more expensive exchange, you can arbitrage the difference. However, prices do change rapidly due to automated trading bots. You need to be quick as any differential could disappear while you are making your trades. Also, consider any fees you might have to pay in your profit calculations.

Cash-and-carry arbitrage

Cash-and-carry arbitrage is nothing new when it comes to futures and is a market-neutral position. Market-neutral positions involve buying and selling an asset at the same time in equal amounts. In this case, a trader goes long and short on an equal amount of identical futures contracts apart from their price. Crypto futures offer a significantly higher profit margin for cash-and-carry arbitrage than traditional commodity futures. 

There’s much less trading efficiency compared to older markets and bigger arbitrage opportunities. To successfully use this strategy, you need to find a point where the BTC spot price is lower than the futures price.

At this point, simultaneously enter into a short position with a futures contract and purchase the same amount of bitcoin on the spot market to cover your short. When the contract reaches maturity, you can settle the short with your purchased bitcoin and arbitrage the differential you initially found.

So why does this opportunity occur in the first place? People are willing to pay a higher futures price if they don’t have the money to purchase BTC now but think the price will rise in the future. Let’s say you think in three months BTC will be worth $50,000, but it’s currently at $35,000. 

At the moment, you have no money but will do in three months. In this case, you could enter a long position for a slight premium at $37,000 for delivery in three months. The cash-and-carry arbitrageur is essentially holding the BTC for you for a fee.

Closing Thoughts

Bitcoin futures trading takes a tried and tested derivative from traditional finance and brings it to the crypto world. Crypto futures markets are now extremely popular and can easily find trading platforms with high trading volume and liquidity. Still, trading on Bitcoin futures markets involves high financial risk, so make sure you understand the working mechanisms of futures trading before getting started.

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