Futures are an agreement to buy or sell an asset on a specific future date at a specific price.
Once the futures contract has been entered, both parties have to buy and sell at the agreed-upon price, irrespective of what the actual market price is at the contract execution date.
The goal is not necessarily profit maximization. It’s a risk management tool, often used in financial markets to hedge against the risk of changing prices of assets that are bought and sold on a regular basis.
Futures are also used in portfolios to balance out price fluctuations on investments, where the underlying asset is particularly volatile.
These contracts are negotiated and traded on a futures exchange which acts as the intermediary.
There are two positions you can take on a futures contract: long or short.
If you take a long position, you agree to buy an asset in the future at a specific price when the contract expires. When you take a short position, you agree to sell an asset at a set price when the contract expires.
A good way to explain this is using the example of an airline who wants to hedge against the rising price of fuel by entering into a futures contract.
Say jet fuel trades at $2 per gallon. An airline expecting the price of oil to rise, buys a three-month futures contract for 1,000 gallons at current prices. The contract is, therefore, worth $2,000.
If in three months, when the contract expires, the price of one gallon of jet fuels is $3, the airline saved $1,000.
The supplier will happily enter into a futures contract in order to ensure a steady market for fuel, even when prices are high. And the same contract will also protect them if the price of fuel unexpectedly drops.
In this case, both parties are protecting themselves against the volatility of fuel prices.
There are also investors who speculate with futures contracts rather than using it as a protection mechanism.
They will deliberately go long when the price of a commodity is low. As prices rise, the contract becomes more valuable, and the investor could decide to trade the contract with another investor before it expires, at a higher price.
Futures are not just for physical assets; they can be traded on financial assets as well.
With Bitcoin futures, the contract will be based on the price of Bitcoin and speculators can place a “bet” on what they believe the price of Bitcoin will be in the future.
In addition, it enables investors to speculate on the price of Bitcoin without actually having to own Bitcoin.
It has two major consequences.
First, while Bitcoin itself remains unregulated, Bitcoin futures can be traded on regulated exchanges. This is good news for those who are concerned about the risks related to the industry’s lack of regulation.
Second, in areas where trading Bitcoin is banned, Bitcoin futures allow investors to still speculate on the price of Bitcoin.
A Bitcoin future will work on exactly the same principles as futures on traditional financial assets.
By anticipating whether the price of Bitcoin will go up or down, speculators will either go long or short on a Bitcoin futures contract.
For example, if an individual owns one Bitcoin priced at $18,000 (hypothetically) and foresees that the price will drop in the future, to protect themselves, they can sell a Bitcoin futures contract at the current price, which is $18,000.
Close to the settlement date the price of Bitcoin, along with the price of the Bitcoin futures contract, would have dropped. The investor now decides to buy back the Bitcoin futures.
If the contract trades for $16,000 close to the future settlement date, the investor has made $2,000 and therefore protected their investment by selling high and buying low.
This is a basic example of how Bitcoin futures work and the exact terms of each future contract may be more complex depending on the exchange, which will include minimum and maximum price limits.
In the short-term, it pushes the price upwards as the overall interest in the cryptocurrency spikes.
The day after Bitcoin futures were launched on the Chicago Board Options Exchange (CBOE), for the first time on a major regulated exchange, the price jumped by almost 10% to $16,936.
Similarly, in the run-up to the launch of Bitcoin futures on one of the world’s biggest exchanges, CME, the Bitcoin price broke through the $20,000 barrier.
The long-term price impact is harder to predict, but in all likelihood, it will continue to boost the price of Bitcoin.
There are several reasons why this is the case.
- As Bitcoin futures can be regulated on public exchanges, it gives people who were previously skeptical as a result of the lack of regulation, the confidence to invest.
- Institutional investors are more likely to offer Bitcoin futures to their clients as a viable investment option.
- It brings more liquidity to the market, making it easier to buy, sell and trade the cryptocurrency, and therefore much more lucrative.
- It opens up the Bitcoin market to a wider investor base, including countries where the trade of Bitcoin has been banned.
As futures are designed to balance out price fluctuations of underlying assets, it could also make the price of Bitcoin less volatile.
There are various possible outcomes.
First, Bitcoin is seen as a sort of poster-boy for cryptocurrencies. Therefore, if the price of Bitcoin sees massive increases in a short space of time, irrespective if this is due to Bitcoin futures or otherwise, more people tend to take notice.
As more people become aware of the cryptocurrency industry, the uptake of altcoins will increase and push prices upwards.
The flipside is also possible; investors might want to sell their altcoins for Bitcoins in order to take part in its bullish run. Large-scale exits could cause a drastic drop in the price of alternative cryptocurrencies.
The more likely scenario is that some of the stronger altcoins, like Ethereum, Litecoin, Ripple, etc., might follow in the footsteps of Bitcoin and become tradeable as futures as well, once interest from investors become strong enough.
There are two separate markets where Bitcoin futures can be traded.
The first option is on selected cryptocurrency exchanges, including BitMEX and OKCoin. Cryptocurrency exchanges have been offering this option for quite some time now, where the trade of Bitcoin futures remain largely unregulated.
The second option is on publicly regulated exchanges. This is a recent phenomenon and part of the reason why we’ve seen the Bitcoin price hike during December.
It started with CBOE’s Bitcoin futures launch on the 10th of December. The Chicago Mercantile Exchange (CME) follow with its launch Dec. 17 set to trade Dec. 18. Brokerage firms like TD Ameritrade and JP Morgan have also expressed their interest to allow access to these markets.