From Bitcoin’s inception in 2009 through mid-2017, its price remained under $4,000. In the second half of 2017, it climbed dramatically to nearly $20,000 but descended rapidly starting in mid-December. The peak price coincided with the introduction of bitcoin futures trading on the Chicago Mercantile Exchange. The rapid run-up and subsequent fall in the price after the introduction of futures does not appear to be a coincidence. Rather, it is consistent with trading behaviour that typically accompanies the introduction of derivatives markets for an asset.
What are derivatives?
A derivative is a financial contract between two or more parties based on the future price of an underlying asset. Financial derivatives are discussed a lot when it comes to the crypto industry, especially concerning futures contracts for Bitcoin or altcoins. The contract can be signed between two or more parties that want to buy or sell a particular asset for a specific price in the future. The value of the contract will therefore be determined by changes or fluctuations in the price of the benchmark it derives its value from.
Derivatives are used in many areas but mainly for hedging purposes, namely when investors want to protect themselves from price fluctuations. In this case, signing a contract to buy an asset for a fixed price would help mitigate related risks. Another way to take advantage of derivative trading is speculation when traders are trying to predict how the asset’s price might change over time. That is the reason why high-profile American investor Warren Buffet once called derivatives “financial weapons of mass destruction,” sharing a commonly held view that they were to blame for the 2007-2008 global financial crisis.
There are four major types of derivatives: futures, forwards, swaps and options.
- Futures oblige the buyer (or buyers) to purchase the asset at a previously agreed-upon price on a specific date in the future. These futures are traded on exchanges, and the contracts, therefore, are similar and standardized.
- Futures and forwards are similar types of contracts with only slight differences. As for forwards, this type of contract is more flexible and customizable for the needs of both traders. As forwards are normally traded on over-the-counter (OTC) exchanges, counterparty risks should always be taken into account.
- Options, as the name suggests, grant the buyer the right but not the obligation to purchase or sell the underlying asset at a certain price. However, according to the terms of the contract, the trader is not necessarily obliged to buy the asset, which is a key difference between options and futures.
- Swaps are derivative contracts that are often used between two parties to exchange one type of cash flow for another. The most popular types of swaps are related to interest rates, commodities and currencies. Normally, swaps imply the exchange of a fixed cash flow for a floating cash flow. That is, a trader can choose an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.
In 2017, the peak bitcoin price coincided with the day bitcoin futures started trading on the Chicago Mercantile Exchange (CME). These price dynamics are consistent with the rise and collapse of the home financing market in the 2000s. It is suggested that the mortgage boom was driven by financial innovations in securitization and groupings of bonds that attracted optimistic investors; the subsequent bust was driven by the creation of instruments that allowed pessimistic investors to bet against the housing market. Similarly, the advent of blockchain introduced a new financial instrument, bitcoin, which optimistic investors bid up until the launch of bitcoin futures allowed pessimists to enter the market, which contributed to the reversal of the bitcoin price dynamics.
A futures contract is an agreement between two parties — generally two users on an exchange — to buy and sell an underlying asset (BTC in this case) at an agreed-upon price (the forward price), at a certain date in the future. While the finer details may vary from exchange to exchange, the basic premise behind futures contracts remains the same — two parties agree to lock in the price of an underlying asset for a transaction in the future.
Bitcoin Futures Strategies
Since futures contracts reflect the expectations of market participants, indicators such as the BTC Long/Short Ratio can provide a quick view of general sentiment. The BTC Long/Short Ratio, compares the total number of users with long positions versus those with short positions, in both futures and perpetual swaps. When the ratio stands at one, it means an equal number of people are holding long and short positions (market sentiment is neutral). A ratio higher than one (more longs than shorts) indicates bullish sentiment while a ratio below one (more shorts than longs) indicates bearish market expectations.
Traders can also use futures to protect themselves from any price fluctuations. For instance, they can enter a short position with a futures contract and a long position in the spot market. But as the expiry of the futures contract approaches, the trader could sell bitcoins in the spot market triggering a sharp fall in the price and cause the value of the short futures positions to rise, netting the trader a higher profit. Analysis from Arcane Crypto has suggested that traders may manipulate the market using futures contracts this way. Their research illustrated that the price of bitcoin falls on average 2.27 per cent the day before CME futures are settled, and 15 out of 20 of these days were negative for the bitcoin price.
As Bitcoin becomes boring for many in the get-rich-quick crowd with volatility ebbing, trading in derivatives of the largest cryptocurrency is exploding. Traders looking for windfall profits that come from taking more risk are migrating to derivatives markets, making use of leverage to increase the potential gains in the absence of volatile price movements of the underlying. Both BitMex and Binance offer Bitcoin futures contracts that can be leveraged more than 100 times and often with no expiry date (i.e. perpetual futures contracts). “When trading with leverage, traders don’t have to tie up as much capital as you would in a trading spot,” Binance CEO Zhao Changpeng told Bloomberg. “This makes trading futures cheaper. This is the reason why futures trading in traditional markets is higher than spot trading.”
But for some, speculation is tantamount to gambling. And while leverage, using borrowed cash to increase one’s exposure in a financial asset, can amplify gains, it can also amplify losses. In a large enough market, extended losses can have spillover effects into other financial markets and create the potential for a financial meltdown, which is why government regulators across the globe are taking a hard stance on crypto derivatives.
Bitcoin options are a form of financial derivative that gives you the right, but not the obligation, to buy or sell bitcoin at a specific price, known as the strike price, at a certain date of expiry. You pay a premium, usually cheaper than buying cryptocurrency outright, in order to buy an option. Unlike buying bitcoin via a cryptocurrency exchange, options enable you to take a speculative position on the future direction of a market price. There are two types of options, call options and put options, and you can go long/short on either of them.
Bitcoin Call Options
Buying a bitcoin call option gives you the right, but not the obligation, to purchase a specific amount of bitcoin at a set price (the strike price) at or before the expiration date. You’d buy a call option if you believe the market price would increase. If your prediction was correct, and the market price increased above the bitcoin option’s strike, you’d be able to buy bitcoin at the prespecified price. How far the underlying bitcoin price rose past the strike price, would influence how much profit you’d make from the trade. If your prediction was incorrect, and the price of bitcoin declined instead, you could let the options contract expire worthlessly, and only lose the premium you paid to open the trade.
Bitcoin Put Options
Buying a bitcoin put option gives you the right, but not the obligation, to sell a specific amount of bitcoin at a set price, at or before the expiration date. You’d buy a bitcoin put option if you expected the market to decline in price. If your prediction was correct, and the bitcoin price declined below your chosen strike price, you could sell your bitcoin holding at a higher price than the new market value. How far the underlying bitcoin price decreased below the strike price, would influence how much profit you’d make from the trade.
If your prediction was incorrect, and the bitcoin price increased instead, you could let the options contract expire and you’d only lose the premium.
Bitcoin Options Strategies
Options contracts, like futures, are also tools for risk management but are a bit more flexible since they are not accompanied by any obligations for buyers.
We can consider Bitcoin miners as potential beneficiaries of these contracts, where they can purchase put options to secure a certain rate for their mined BTC in the future. However, unlike futures contracts, where the miners would be obliged to sell their BTC regardless of the price, here they can choose not to sell if Bitcoin rises significantly.
Speculation remains another reason behind the use of options because they allow conservative market participants to make their bets with much smaller sums at risk (the premiums) compared to futures contracts.
There are different bitcoin options strategies that can be used depending on your motivation behind trading – whether it is to speculate on bitcoin’s price or hedge against any risk to an existing BTC holding.
For speculative traders, there are a range of options strategies that can be used to take advantage of options volatility. For example, a straddle options strategy involves simultaneously buying and selling an equal number of bitcoin puts and calls with the same strike price and the same expiration date.
The idea is that the profit to one position would offset the loss to the other, ensuring you have a net profit – this means you could take advantage of bitcoin volatility, regardless of which way the market moves. However, if the loss from one bitcoin option is larger than the gains to the other, you’d have a net loss.
The most common options strategy for hedging an existing holding is a covered call – this involves writing a call option for the same number of BTC that you already own. If the market price declined, the short call option would offset some of the losses to your BTC holding. If the market price increased, then you would likely have to sell your holding, but you’d have earned the option premium.
While options can be used as purely speculative investments, the most successful asset managers use options as a way to effectively mitigate risk and maximize potential earnings. By combining the four basic options trades (click here) with the two basic stock trades (long and short), investors can create a range of more sophisticated strategies to optimize their portfolios.
Understanding Options Trades
Call and put options for a Sep. 25, 2020 expiry date are shown in the chart below. The blue circle marks options contracts with a strike price of $11,000, meaning that the holder of a call option for this contract will be able to buy Bitcoin at $11,000 on Sep. 25, whereas the holder of a put option will be able to sell it for the same. The green and red circles mark the average premiums for call and put options respectively.
If Robbie was to buy this call option today, he would pay $1,355.10 as a premium to reserve the right to buy Bitcoin at $11,000 on Sep. 25. Similarly, Adam would pay $2,678.28 to buy his put option for the right to sell Bitcoin at $11,000 on Sep. 25.
The difference in these premiums is representative of market sentiment, where the counterparty agreeing to buy Adam’s Bitcoin believes it to be a riskier bet than the one agreeing to sell to Robbie.
All told, the bitcoin derivatives market looks to be in rude health, even if it remains small when compared to other commodities markets. For one thing, traditional investors are likely to be enticed into crypto as a consequence of their familiarity, since derivatives are routinely used in regular financial markets. In fact, a great many institutional traders have thus far been reluctant to engage with crypto due to a paucity of tools to hedge trades and manage risk. 2020, then, and the decade it heads should bring greater leverage for crypto derivatives, including those in the DeFiecosystem, greater liquidity, and greater competition from players old and new.
Ultimately, for Bitcoin to become a widely accepted asset class, many argue, it needs a transparent market that is not easy to manipulate. Achieving this will require an influx of new capital, increased liquidity, reduced volatility, organic price formation and the trust of large-scale institutional investors. Each quality derivative product has the potential to take Bitcoin a step closer to such legitimacy.
A few quick references below: