What are Bitcoin Futures and How do They Work?
Confirmed by The US Commodity Futures Trading Commission (CFTC), CME Group and CBOE met the requirements for regulated training, while Cantor Exchange will also be allowed to debut Bitcoin binary options. With institutions opening up their minds and wallets to cryptocurrency investments, the popularity and confidence in the asset will increase for the average investor.
Novice investors in the digital currency space will want to follow suit with the advanced investors of today and may believe that a more regulated investment such as futures are safer for them compared to simply purchasing bitcoin through an exchange. Before you or any investor decides to invest in futures trading make sure you know how it works! This article will be a simple presentation of a futures contract, however, let it be known that futures contracts are extremely risky and the examples in this article may not reflect just how risky futures trading is.
How Do Futures Contracts Work?
For starters, futures contracts allow traders to speculate on the price of an asset without having to own the asset. These traders make a profit by buying or selling a contract based on the price movement of the asset into certain direction. If a trader is selling their futures contract they are considered a short speculator, and if a trader is buying a contract, they are called a long speculator.
There is often a minimum number of contracts that a trader must purchase but in this example we will keep it simple, let’s say you want to buy one contract and the price is $50,000 ($10,000 per bitcoin) because the bitcoin futures contracts will represent five bitcoins. Before you own the contract, you will need to deposit the initial margin. Similar to the down payment the initial margin is a percentage of the total contract usually around 5 to 10 percent. If you put down the initial margin of 10 percent, you will own the contract after you deposit $5,000 into your trading account.
The CME Group has set the tick or the minimum price movement for Bitcoin contracts at $5.00. So even if the price of Bitcoin price increases $4, you will not gain or lose money on the contract. This is because $4 is below the minimum tick. However, each time bitcoin increases by $5, you will gain or lose $25 on his contract (because each contract is made up of five bitcoin). Starting to make sense?
So, let’s say you own a contract and the price of bitcoin increases $100 in a day, and the minimum tick is $5, with each tick you earn $25 so you will gain (20)*(25)= $500 in a day. On the contrary, if the bitcoin price decreased $100 during a trading day, you will lose $500 on your contract and you will see funds in your trading account diminish.
Keep in mind though that you only payed $5,000 for a contract worth $50,000. The $45,000 that you didn’t have to pay is borrowed money, in other words the bitcoin contract is leveraged. Because of this leverage, futures contracts are considered to be very risky.
Now let’s imagine that after four weeks the Bitcoin index (price) increases by five percent or in other words, 500 index points. After four weeks, Bob has earned a profit of $5.00(500)=$2,500 viz. Bob has earned a 50 percent profit on his initial deposit. On the other hand, if the indexed declined by five percent Bob will lose $2,500, a 50 percent loss on his contract. This incredibly large return can very quickly make you rich however can be just as devastating for those who are on the wrong end of the investment.
Moving forward, be careful investing in these proposed bitcoin futures and as a piece of wise advice don’t invest in something you do not thoroughly understand and have complete knowledge of.