An Overview of How Bitcoin Futures will Work at the CME

Friday was a big day for the eventual launch of Bitcoin futures on numerous exchanges. The CFTC has confirmed that the proposals for futures listingsby the CME group and CBOE had passed requirements for regulated trading.

Futures contracts will allow the trader to enter a position and speculate on the price of Bitcoin (either up or down). They are a derivative instrument which means that they will derive their value from the underlying.

Although futures contracts have been available at Exchanges such as Bitmex, the standardised exchange traded types on at the CBOE and CME will be a great deal more important.

We have previously covered the impact that the eventual launch of these products had on the markets and the great amount of enthusiasm that followed.

The Contract Specifics

These contracts are an agreement between the buyer and the seller that at some point in the future the buyer will buy the Bitcoin from the seller at the price that was agreed.

This means that the buyer of a Bitcoin Future is able to lock in the price of Bitcon at some future date and buy it then. Of course, with most futures contracts, the buyer does not actually buy the Bitcoin from the seller. It is rolled over and profits / losses are collected.

They could either "go Long" and buy the contract or they could "go short" the contract and sell it. The latter action is what many institutional investors would like in order to hedge their long positions in Bitcoin.

Contract Exposure

The Bitcoin futures will be structured such that each contract will represent at least 5 bitcoin. This will mean that when a trader enters a position with the futures, they will be exposing themselves to the movement of 5 Bitcoin.

Initial Margin

Futures are also known for the amount of leverage that a trader can take on. This is possible because the trader only has to put up a certain percentage "margin" on the contract. In the case of Bitcoin, the margin will be 10% of the position that is staked.

Tick Size

Another important characteristic for a futures contract is the "tick size" that is applicable to the contract. In the case of Bitcoin, this tick size will be $5. This means that gains / losses will only be realized when the tick size is greater than $5.

When the tick size is greater than $5, the gain / loss for one contract will be $25 (the four Bitcoin in the contract).

Simple Example

In order to best understand the mechanics of a futures contract, let us look at a simple example of a trader who wants to go long Bitcoin through the use of the Futures contract.

Assume that our trader would like to take a position on 12 Bitcoin. This would mean that they would need to buy 3 Bitcoin futures contracts. They would have an exposure of 12 * Future Price.

The future price is the price at which Bitcoin is trading for on the futures market at that expiry. For the sake of this example, let us assume that the contract is for Dec 2018 expiry and the Future price is $20,000.

This would mean that the underlying exposure of the trader is $240,000. The trader would then be obligated to put up a 10% margin on the trade, which in this case is $24,000.

If the Future price of Bitcoin were to increase by $100, this would mean that the value of the contract has increased to $241,200. This would mean that the trader would gain a profit of $1,200 which would be market to market and put into his futures account.

Higher Leverage, Higher Risk

Given that the trader will only need to put up a much smaller amount as margin than the total required, the trader will have the benefit of leverage.

Leverage can be seen as a double edged sword that can work to the benefit of the trader when the position is in his favor. However, it will also quickly erode his margin if the trade goes in the opposite direction.

Going back to our example above, although the price of Bitcoin has only moved by a meager 0.5%, the $24,000 has increased in value by 5%.

Of course, we know that Bitcoin is a whole lot more volatile than a 0.5% daily move. If Bitcoin was to fall by 10%, this would mean that the position would go from $240,000 to $216,000 and the entire amount of the margin that was staked will be depleted.

Margin Call

In order to protect the exchange from situations in which the trader enters a negative position and owes the counterpart money, the exchange will request a margin call from the trader.

In order to make sure that this does not occur, a broker will set a minimum maintenance margin for the trader. If the position of the trader falls to this minimum margin maintenance level, the trader will get what is called a "margin call".

This will require the trader to top up their position such that the broker is certain that the trader can cover it in the event of more adverse movements in the price of Bitcoin.

Price Limits

Given the extreme volatility in the price of Bitcoin, the CME has introduced some volatility limits that will try to mitigate the effects on the market.

The CME will institute price fluctuation limits of 7%, 13% and 20%. If there is a movement in the price of the Future that is +/- 7% greater than the previous day price then a two minute monitoring period will be instituted.

If the price moves beyond the 7% limits then trading will be halted for two minutes. Traders will still be able to create orders within this 2 minute halt yet this will not be fulfilled till the halt is completed.

After this, the price limit will increase to 13% with no halt in place. However, if the price exceeds 20% +/- then trading for the rest of the day must occur within the 20% up or down limit.

Launch Date

The futures at the CME are still waiting for approval from the regulators. The timeline given by the CME is that they should be ready to go by the end of Q4 of 2017.

Of course, traders will not only have the CME futures to choose from. The CBOE and Nasdaq are also launching Bitcoin futures in 2018. There were also reports that Cantor Fitgerald wanted to launch Binary Options on Bitcoin.

Given that these derivatives will provide a unique way for a number and institutions to hedge the risk that they face in Bitcoin, the hope is that they will eventually temper the volatile nature of the asset.

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