Basics of Bitcoin Futures: How are They Priced?

What are the basics of Bitcoin futures and how are they priced? Since investing in crypto coins, or Bitcoin futures contracts, and even in the Initial Coin Offerings or ICOs are highly speculative and risky, you should go ahead with it after considering a few factors such as:

  • Your personal situation, which is unique and
  • Your knowledge about the particular product you want to invest in.

Way back in 2009 when Bitcoin was launched in the market for the first time, it created a lot of buzz all over but no one was very sure how long it would last, let alone how far the coin would go.

The primary reason behind people and the authorities being skeptical of Bitcoin was that it was traded on a decentralized exchange. They thought that it would lead to several issues such as:

  • Money laundering
  • Illegal transactions and even
  • Terrorist funding.

However, in spite of all the controversies, since then, the crypto market, and Bitcoin in particular, has come a long way and today it happens to be the primary determinant of the price of all other crypto coins you may find in the market.

The value of crypto and Bitcoin has exploded exponentially and the interest among investors has grown significantly over the years.

In fact, it is the popularity of Bitcoin that has resulted in the development of several other variants of crypto coins as well as other ways to trade the coin.

One such option open to the market participants is trading Bitcoin futures contracts.

Launched in December 2017, these futures contracts have gained a lot of attention since then among the investors giving them exposure to the Bitcoin market in the same way as any other commodity would.

The good thing is that you do not need to hold the principal crypto coin for it. In addition to that, Bitcoin futures contracts also offer hedging and risk alleviation possibilities.

Sounds very impressive to you? Well, if you are thinking on the lines of investing in Bitcoin futures contracts, you should first know the basics and more about these contracts and their pricing since it involves a certain amount of cost and risks.

You are fortunately in the right place for that. Keep reading this article which will clarify all your doubts and make you confident when you invest in Bitcoin futures contracts.

What are the Basics of Bitcoin Futures and How are They Priced?

Basics of Bitcoin Futures

Before knowing the complex pricing methods and its effect on the entire crypto market, it is important that you know about some of the fundamentals of these Bitcoin futures contracts.

These contracts are ideally an agreement that you enter into in which you promise or buy or sell Bitcoin at a speculated price at a predetermined point in time in the future.

As of now, you can trade Bitcoin futures contracts on only two publicly regulated exchanges such as:

  • The Chicago Board Options Exchange or CBOE and
  • The Chicago Mercantile Exchange and Chicago Board of Trade or CME.

In both these exchanges, the Bitcoin futures contracts are settled in cash.

This means you can take cash at the time of settlement of the futures contract if you do not want to take physical delivery of Bitcoin.

However, the working process of these two exchanges is pretty different.

In the case of CBOE, the underlying asset is the price of Bitcoin determined at the Gemini Exchange auction and is expressed in US dollars.

On the other hand, in the case of the CME futures contracts the underlying asset is the Bitcoin Reference Rate or BRR that is derived from a summative price of Bitcoin at some of the major exchanges in the US and it is also expressed in US dollars.

Both these exchanges have their unique margin requirements to trade Bitcoin futures contracts.

As for CBOE, the margin requirement for Bitcoin futures contracts is 40% as against 35% of CME.

Yes, this is quite high because, as said earlier, the prices of Bitcoin are very volatile in nature and the market itself is pretty immature.

However, the CME launches new Bitcoin futures contracts every month with two additional December contract months and all are typically listed for 6 months. The CME also puts forward monthly contracts for cash payment.

You will need to go through brokers if you want to buy and sell these futures contracts. Some of the most favored brokers by the investors are:

Trading of these Bitcoin futures contracts typically start when an initial price is set by the market makers for these contracts.

However, over time, when the momentum of the market gains pace, the supply-demand system comes into effect and becomes the priority.

This helps in determining the price of the futures contracts.

It is the volatile nature of Bitcoin price that is taken advantage of while dealing with the Bitcoin futures contracts or any other crypto futures for that matter without needing holding the actual crypto coin for that.

Before you start trading, it is important that you know a few important properties of Bitcoin futures contracts in order to trade them successfully and make profits. These are:

  • Leverage – This is what lures the investors towards it, which also makes Bitcoin futures contracts trading quite capital-efficient. The money you will need to spend for it will however depend on the current market price but you can also open a futures position paying just a fraction of the cost if only you use leverage. The more leverage you use, the less you pay to open a position.
  • Collateral – As said earlier you will need to put in an initial margin to open a futures position. This margin amount is a percentage of the total notional value of the futures position and acts as collateral.
  • Maintenance margin – There may also be a maintenance margin charged on the other hand which is the minimum amount you need to pay in order to keep your trading position open. These margin checks are unremitting. It helps in calculating margin utilization. When you hit this maintenance margin limit, your position will be liquidated.
  • Funding rates – If you go for the perpetual contracts, it will be settled differently which needs the futures prices and the index prices to match or converge. Funding rate ensures this. This rate is calculated on the basis of the difference in prices between futures and spot markets.
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Talking about the funding rates, you will either receive or pay funding payments according to the open market positions.

However, this can have undesirable effects on the traders.

For example, it can make it very difficult for the traders to hold a long position if the funding rates result in an inflamed bull market.

You may ask now, why then people favor investing in Bitcoin futures contracts and whether you should or should not follow their footsteps.

Well, you are the best judge for it but for that you will need to know the merits and demerits of Bitcoin futures contracts first.

The advantages of trading Bitcoin futures contracts include:

  • Ability to make profit irrespective of rise or fall in price
  • Ability to use leverage to gain exposure at a fraction of the total cost and
  • Ability to hedge the portfolio.

On the other hand, the downsides of Bitcoin futures contracts trading include:

  • The highly volatile nature that makes it pretty difficult to determine the movements of the market and
  • The high risks involved due to high leverage that needs following a strong risk management strategy.

The underlying crypto asset, Bitcoin in this case, can have a radical effect on the prices of these futures contracts due to the sole fact that Bitcoin by itself is extremely vulnerable to volatility.

This can change the prices of the Bitcoin futures contracts significantly.

Therefore, though you may use some theoretical formulas to make some simple calculations based on the spot price or current price of Bitcoin to determine the futures price, you will need to take the wild swings in the spot price into consideration.

In order to calculate the Bitcoin spot price, you can use a reliable Bitcoin USD Price Index.

These indices show the simple average of the exchange prices of Bitcoin and USD on the global scale.

The prices are expressed as the mean of the bid/ask spread across several different global exchanges.

These prices are calculated on the basis of a few specific minimum criteria related to the trading volumes on the exchanges, the minimum size of each trade, and other factors.

And, when you calculate the Bitcoin Future Price, you can use the data available on the exchanges to calculate the reference rate.

However, this is not easy, mind you, which brings to the next important section of this article.

Calculation of Price 

The calculation of the price of Bitcoin futures contracts follows almost the same method in which the prices of all other futures contracts are calculated. The value is typically derived from the underlying security.

Therefore, the prices of the Bitcoin futures contracts depend on the spot prices of Bitcoin.

This refers to the prevailing price of the coin in the market in which the coin is bought or sold.

If there is any movement in the price of Bitcoin in the market, the price of the Bitcoin futures contracts will be affected.

This means that these prices, both the Bitcoin futures price and the spot price of Bitcoin, will have a significant relationship and will need to be in accord with each other in spite of the fact that both these prices are completely different in nature.

If you have some mathematical and technical knowledge, it will be easy for you to understand the theoretical formula used to calculate the Bitcoin futures contracts price from the spot price. If you are not, do not bother.

The formula used to calculate the futures contracts price is:

Futures Price=Spot price x (1+rf – d)

Here, d = dividend and rf = risk-free rate on an annual basis.

However, you will need to customize this formula in order to use it for calculating Bitcoin futures contracts prices.

The two specific aspects that you will need to customize are as follows:

  • First, you will need to change the risk-free rate to daily basis instead of an annual basis and
  • Second, you will need to remove the ‘ d’ component because there is no dividend offered in the case of Bitcoin.

Therefore, the formula to use to calculate the Bitcoin futures contracts prices will be:

Bitcoin Futures Price = Bitcoin Spot price x [1+rf (x ÷ 365)]

Here, x = number of days to expiry.

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The formula to calculate the Bitcoin futures contracts prices depends on the cost of carry concept and also contains a provision to calculate the returns on the investment. This return is the same as the risk-free rate that is offered over a period till the expiry of the contract.

If you do not use any arbitrage then the price of the futures contracts will be the total of the cost of carry and the spot price. This is clearly reflected in the formula.

However, if there is a slight difference in the price, it will be due to the perception of the market regarding volatility and the brokerage charges. This however, will alter the actual payout by a couple of points.

This formula, however, does not consider the situations in which the price of the Bitcoin futures contracts will be impacted drastically because it is theoretical. These situations include:

  • Recent developments related to Bitcoin
  • Any apparent volatility in price and its effect on the remaining days of expiry of the contract.

In such situations, pricing the Bitcoin futures contracts really becomes a guessing game.

However, when the long term dynamics of both the spot prices and futures prices are taken into consideration, the Common Factor Component or CFC Model will be very useful to determine the price of the futures contracts.

This model will consider the situations when both the futures and spot markets may shift from the long-term equilibrium due to the impact of any information or event in relation to the prices.

The CFC model will be able to uncover the common factor between the spot and futures prices to interpret the long-term dynamics driven due to it as the efficient price. This will comprise the basic value of the coin. 

This complex method uses Gonzalo and Granger permanent-transitory decompositions to estimate the common long-memory components and defines the common factor as gt = α’⊥ yt.

Here, the α⊥ vector satisfies the α’⊥ α = 0.

And, the yt here corresponds to the permanent-transitory decomposition which is calculated as follows:

yt = A1gt + A2zt

Where, A1 = β⊥(α’⊥β⊥)– 1 and  A2 = α(β’α) 1 in which the β⊥ vector satisfies β’⊥β = 0.

This model presents a co-integration between the spot prices and future contracts prices. This will allow you to determine the contribution of each spot market and the future markets to the common factor.

This contribution can however be determined by another formula which is:

CFC= αs ÷ αs – αf

And, CFCs= (−αf ÷ αs – αf) = 1 – CFCf

The value of these contributions are calculated by the rate of the correction parameter α = (αf , αs).

According to the formula, the market which will have a smaller α will have a larger CFC and therefore will dictate the process of price discovery.

On the other hand, the market which will have a larger α will have a smaller CFC and will therefore primarily follow in the price discovery process.

There are also other methods of calculating the futures prices such as the Hasbrouck Information Share model which are even more complex and perhaps beyond the scope of this article for a proper explanation. 

Real World Price 

Well, if you consider determining the real-world price of the Bitcoin futures contracts you will need to look over and above the theoretical calculations mentioned above.

Ideally, the price of Bitcoin futures contracts in the real world usually experiences wild swings often and in either direction.

If you want to have a proper understanding of these price swings along with the unpredictability associated with the price detection mechanism of the futures contracts, you will need to look at the behavior of the futures contracts in the recent past.

For this you will need to consider the spot price of Bitcoin as well as the prices of the futures contracts that have expired a couple of months back.

Depending on the market conditions, you may observe a few specific aspects regarding the price of the futures contracts such as:

  • It may be close to the spot price
  • It may be higher than the spot price
  • It may be below the spot price.

The reason for such things to happen is the comparative differences between the spot price and the future prices in the market.

For a better understanding of the real world prices of Bitcoin futures contracts in the two markets, you will need to understand the time-varying Granger causality procedure with relation to the CBOE and the CME. 

This process needs maximum order assimilation for the VAR or Value at Risk but you will not need to pre-filter the data.

There are multiple root tests used in this method in order to determine the stability of the spot prices and the log futures.

Considering all of the different variables available, the time-varying Granger causality analysis is conducted based on the VAR model.

This will allow integrating the data as well as set the lag addition parameter to unity.

Without going into the extremely complicated test results of time-varying Granger causality, here are the common and major findings of the tests that will help you to understand the effects on each of these two markets.

As for the CBOE market, the effects caused by the Gemini auction price or the spot price on the futures prices are considered.

In this market, there is no significant effect caused due to the Granger causality episodes on the Gemini auction prices and the CBOE futures prices unless there are any recursive evolving approaches detected in any episode.

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On the whole, the CBOE futures market typically dictates the spot market.

On the other hand, if you consider the CME market, the Granger causality episodes are run from the spot prices or Bitcoin Reference Rates to the CME futures prices.

In this particular market, a significant effect is caused only when there is a rolling window approach detected in an episode as well as a recursive evolving approach, both at different times.

In such situations, the spot prices and the CME futures prices seem to have a casual and bi-directional relationship.

Considering its duration and magnitude, the CME futures market dictates the core spot market in terms of Granger causality.

Therefore, when you consider the two different markets, there will be a unidirectional Granger causality effect on the Bitcoin futures to CBOE spot markets but it will be a bidirectional Granger causality effect in the case of the CME market. 

With all these complex calculation processes to determine the price of the Bitcoin futures contracts, one thing that can be noted very clearly is that the Granger causality aspect is a very important factor in this entire process.

More precisely, it is the Granger bi-directionality that is not easy to overlook from the futures which is stronger in comparison to the spot prices.

This suggests that the Bitcoin futures market governs the spot market by the virtue of its stronger lead-lag responses. 

Price Differences 

Finally, the price differences between the spot prices and Bitcoin futures prices need some explanation here as well in order to understand the method of pricing in a better way.

You may wonder why exactly there is a difference between the spot prices and the prices of the Bitcoin futures contracts given the fact that the two follow each other closely.

Well, to understand that, you will need to go back to the theoretical formula which holds true only in those cases that are without arbitrage and does not take into account the real-world perception of prices and its volatility, as mentioned in the earlier section of the article.

In the real world, the opposite happens due to the perceptions of the different participants in the market.

They typically include the probable impacts that the price volatility may have especially in the futures prices.

An example will make things clearer to you. Imagine there are only two days left until the expiration of a futures contract. In that case, the formula used to calculate the futures price will only tell you about the price of the Bitcoin futures contract.

This price will typically stay close to the spot price because the time left is very little.

Quite naturally you may think that both the prices will be at par within hours to expiry. However, this may not always be true.

There may be situations when the futures contracts price may shoot up significantly or even fall down dramatically due to high volatility.

Such situations often occur especially when there is a big event surrounding the crypto market, and it does not necessarily have to be a sudden ban on crypto.

It can be even simpler events such as a new regulation imposed on crypto by the government or a significant rise in demand for Bitcoin.

In such situations, the perception of the market participants will be seriously affected and it is all reflected in the current or spot price of the particular asset, Bitcoin in this case.

Bitcoin, as you may know, can be traded around the clock for 365 days.

This is a perfect recipe for the prices to experience high volatility, especially within hours or even minutes to expiry.

However, everything will largely depend on the local developments.

On the other hand, when you consider the futures market, it is open only for a specific period of time in which the trading usually happens.

Therefore, there may be situations when the price of the Bitcoin futures contracts closed close to the spot price one day but experienced a significant hike the next day due to an enormous increase in the price of Bitcoin overnight as a result of a major development.

This will lead to a much wider gap between the spot price and the Bitcoin futures contracts price.

With all these aspects taken together, there is one thing that can be said about the Bitcoin Futures contracts.

It is the complexities in evaluating these futures as well as the volatile nature of Bitcoin price itself which makes the Bitcoin futures contracts so interesting to invest in. 

Conclusion 

Therefore, you can see there are a lot of inconsistencies and wide impact due to volatility on the price discovery methods of Bitcoin futures contracts. Add to that, the 24/7 trading in spot prices makes it all the more complex to evaluate them.