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Derivatives are tradable shares or futures whose value is derived from the underlying asset. In the case of cryptocurrency futures, the underlying asset is usually Bitcoin (BTC) or another common cryptocurrency.
Derivatives, in general, are complex, high-risk financial tools that can be used to manage risk by hedging.
While traditional markets have been using various forms of derivatives for thousands of years, their modern varieties can be traced back to the 1970s and 80s, when the Chicago Mercantile Exchange and Chicago Board of Trade introduced futures contracts.
The most common types of derivatives include futures, forwards and options, which are based on a variety of assets, including stocks, currencies, bonds and commodities. Given the sheer number of derivatives available today, the market’s size is difficult to ascertain, with estimates ranging from trillions to over a quadrillion dollars.
Among crypto derivatives, Bitcoin futures were the first to go mainstream and remain the most traded in terms of volumes. BTC futures were being traded on smaller platforms as early as 2012, but it wasn’t until 2014 that the growing demand prompted major exchanges, namely CME Group Inc and Cboe Global Markets Inc, to follow suit.
Bitcoin futures are now among the most popularly traded securities in the space, with top exchanges such as OKEx logging billions of dollars in daily value.
BTC futures aggregated daily volumes. Source: Skew
What is a Bitcoin futures contract?
A futures contract is a deal between two parties — usually two exchange customers — to purchase and sell an underlying asset (BTC in this case) at an agreed-upon price (the forwards price) at a future date.
Although the finer details differ by exchange, the fundamental principle of futures contracts remains the same — two parties commit to lock in the price of an underlying asset for a future sale.
Many markets, for the sake of ease, do not permit futures contract holders to accept the real underlying asset (such as barrels of oil or gold bars) until the contract ends and instead endorse cash payments.
However, physically-settled Bitcoin futures, such as those sold by Intercontinental Exchange’s Bakkt, are gaining traction because real Bitcoins can be exchanged with relative ease in comparison to other commodities.
How does a Bitcoin futures contract work?
Let’s walk through a BTC futures trade on OKEx’s weekly futures market. First of all, the weekly futures market just means that the contract holder is betting on the price of Bitcoin over one week — OKEx also offers bi-weekly, quarterly and bi-quarterly time spans for futures.
So, if Bitcoin is trading at $10,000 today and Adam believes the price will be higher next week, he can open a long position with a minimum of one contract (each contract represents $100 in BTC) on OKEx’s weekly futures market.
When someone buys Bitcoin and holds it (goes long), they are counting on the price going higher, but cannot profit if the price drops. Shorting, or selling an asset today in the expectation that it will reduce in price tomorrow, is how traders profit from price declines.
For this example, let’s say Adam opens 100 long contracts (100 x $100 = $10,000) that collectively reflect his promise to buy 1 BTC on the settlement date next week (8 a.m. UTC every Friday on OKEx) for that price — $10,000.
In the other hand, Robbie thinks Bitcoin’s price will fall below $10,000 next week and intends to go short. Robbie agrees to sell 100 futures, or 1 BTC, at the agreed-upon price of $10,000 on the settlement date next week.
The exchange matches Adam and Robbie and they enter into a futures deal: Adam commits to buying 1 BTC at $10,000 and Robbie commits to selling 1 BTC at $10,000 before the contract expires.
The price of Bitcoin one week later, on the settlement date, will determine whether or not these two traders made profits.
After one week, Bitcoin is worth $15,000. This means that Adam, who agreed to buy 1 BTC for $10,000, makes a $5,000 profit on his deal. Adam just had to pay $10,000 for one Bitcoin, which he would immediately exchange for the existing market value of $15,000.
Robbie, on the other hand, loses $5,000 when he is forced to sell his 1 BTC for the agreed-upon price of $10,000, despite the fact that it is now worth $15,000.
Depending on whether Adam and Robbie used USDT Margined Futures or Coin Margined Futures, OKEx settles the contract in stablecoin Tether (USDT) or BTC, crediting Adam’s or Robbie’s account with the realized profit or loss.
Since futures contracts represent market participants’ views, metrics like the BTC Long/Short Ratio will provide a brief snapshot of general sentiment. The BTC Long/Short Ratio measures the cumulative number of customers with long positions in futures and permanent swaps to those with short positions.
BTC Long/Short Ratio. Source: OKEx.com
When the percentage is one, that means that an equivalent number of people occupy long and short positions (market sentiment is neutral). A ratio greater than one (more longs than shorts) suggests bullish market expectations, whereas a ratio less than one (more shorts than longs) indicates bearish market expectations.
Why do people buy and sell BTC via futures contracts?
Why would someone enter into a futures contract to buy or sell Bitcoin instead of trading BTC directly on the spot market? Generally, the two answers are risk management and speculation.
Future contracts have long been used by farmers seeking to reduce their risk and manage their cash flow by ensuring they can get commitments for their produce ahead of time, at a pre-arranged price. Since farm produce can take time in preparation, it makes sense for farmers to want to avoid market price fluctuations and uncertainties in the future.
Bitcoin’s volatility and price swings also necessitate active risk management, especially for those who rely on the digital asset for regular income, such as Bitcoin miners.
Miners’ earnings are dictated by the price of Bitcoin as well as their monthly expenses. Although the former varies significantly on a daily basis, the latter is usually constant, rendering accurate earnings forecasting difficult.
Furthermore, increasing competition in the mining industry introduces new, non-price-related issues, such as hardware redundancy as a result of increased complexity. In such a situation, the only way for miners to continue operating with reduced risk is to hedge with options such as futures.
However, risk management or hedging is different from speculation, which is also one of the main drivers behind Bitcoin futures contracts. Since traders and speculators aim to benefit from price volatility in either direction (up or down), they need the ability to bet each way — long or short.
Futures contracts give pessimists an avenue to impact the market sentiment, a phenomenon discussed in detail by the Federal Reserve Bank of San Francisco in their research titled How Futures Trading Changed Bitcoin Prices.
Finally, Bitcoin futures are common because they encourage traders to use leverage, allowing them to open positions greater than their deposits as long as they hold a reasonable margin ratio — as calculated by the exchange. Leverage has little effect on any of the factors associated with a derivative and instead helps to magnify risk and reward.
When the demand is bullish, future contracts gain appreciation and can be sold at a premium to the cash price, and vice versa. This gap, known as the foundation, is another useful indicator for gauging market sentiment.
BTC Basis. Source: OKEx.com
When the basis is positive (bullish), it means the futures price is higher than the actual spot price. When the basis is negative (bearish), it indicates that the futures price is lower than the spot price.
Bitcoin perpetual futures or swaps
In addition to the standard futures discussed above, Bitcoin markets also support perpetual swaps, which, true to their name, are futures contracts without an expiry date.
Since there is no settlement date, neither of the parties has to buy or sell. Instead, they are allowed to keep their positions open as long as their account holds enough BTC (margin) to cover them.
However, unlike traditional futures, where the bond price and the underlying asset eventually coincide until the contract ends, permanent contracts have no such future reference period. Perpetual futures, or swaps, use a different method, known as the funding rate, to enforce market convergence at frequent intervals.
The funding rate’s aim is to keep the price of a contract in line with the spot price of the underlying asset, discouraging large deviations.
It is important to remember that the financing rate is a charge that is paid by the two parties to a deal (the long and short parties) rather than a fee that is received by the exchange.
If the value of a permanent contract, for example, continues to rise, why will shorts (people on the sale side) hold a contract open indefinitely? The support levels assists in balancing such a scenario. The market determines the rate itself, which varies.
How do BTC perpetual swaps work?
For example, if a perpetual swap contract is trading at $9,000 (the mark price) but the spot price of BTC is $9,005, the funding rate will be negative (to account for the difference in price). A negative funding rate means that the short holders must pay the long holders.
If the contract price is higher than the spot price, the financing rate is positive — long contract holders must pay short contract holders.
In each of these cases, the funding rate encourages the creation of new jobs, which will put the contract’s price closer to the spot price.
Most exchanges, like OKEx, make funding rate payments every 8 hours as long as contract holders leave their positions open. Profits and expenses, on the other hand, are realised at the time of regular settlement and are directly credited to holders’ accounts.
Funding rate statistics, such as the one seen below, can be used to easily determine industry dynamics and results over any time span. A positive funding cost, once again, indicates that the demand is inherently more optimistic — the swap contract price is better than spot rates. A negative funding rate reflects bearish thinking when it shows that the swap price is smaller than the spot price.
BTC Perpetual Swap Funding Rate. Source: OKEx.com
Like Bitcoin futures, options are also derivative products that track Bitcoin’s price over time. However, unlike standard futures — where two parties agree on a date and price to buy or sell the underlying asset — with options, you literally purchase the “option” or right to buy or sell the asset at a set price in the future.
Despite the fact that crypto options are newer than futures, this month saw Bitcoin options hit an all-time peak in terms of Open Interest of more than $1 billion (OI). The cumulative value (in USD, generally) of outstanding options contracts that have yet to be concluded is denoted by OI. An increase in open interest usually signals a new money inflow into the industry.
Total BTC Options Open Interest. Source: Skew.com
Calls and puts
There are two types of options contracts, call options and put options. Call options give the holder the right to buy an underlying asset at a set date (expiry), and put options give the holder the right to sell it. Each option, depending on associated conditions, has a market price, called the premium.
There are two kinds of options contracts: American and European. An American option can be exercised (that is, bought or sold) at any point before the expiry date, while a European option can only be exercised on the expiry date. OKEx is a supporter of European options.
If the owners of an option does not exercise their right to purchase or sell on the expiry date, the deal simply expires. The holder is not required to make good on it, although they do forfeit the premium — the sum paying for the deal.
For ease, options are often cash-settled, but they bear somewhat different risks than futures. With futures, neither party’s risk nor compensation is constrained (the price of Bitcoin will go everywhere until settlement). However, for options, investors have an infinite potential advantage and a limited potential loss, while option traders have an unlimited potential loss and a very limited potential income (as explained below).
How does a Bitcoin options contract work?
If Bitcoin is trading at $10,000 today, and, this time, Robbie believes the price will be higher at a certain date in the future (let’s say a month later), he can buy a call option. Robbie’s call option has a strike price (the price at which BTC can be bought in the future) of $10,000 or lower.
If Bitcoin is trading at $15,000 a month back, Robbie will exercise his call option and purchase Bitcoin for $10,000, making an immediate profit. However, if Bitcoin is trading at $9,000 a month back, Robbie will simply let his option expire.
However, in none of these cases have we found the choice premium. The premium is the sum Robbie will spend to purchase the call option — that is the option’s selling price. If the premium is $1,500, Robbie can pay $1,500 today in exchange for the right to purchase Bitcoin at $10,000 a month later.
This means that the actual breakeven price for Robbie is $10,000 + $1,500 = $11,500 — Bitcoin must be more than $11,500 for him to prosper. Robbie can only lose his $1,500 premium if he decides to let his option expire.
In fact, although Robbie’s profit opportunity is limitless (or, rather, just constrained by the price of Bitcoin), his loss is limited by the premium he charged. In no case will Robbie risk more than the contract’s premium.
Then there’s Adam, who thinks Bitcoin’s price will fall over the next month. He will purchase a put option with a $10,000 strike price. This means he’ll be able to trade Bitcoin for $10,000 in a month’s time, regardless of the spot price.
After a month, if Bitcoin is trading for less than $10,000, say $8,000, Adam will benefit from exercising his option and selling BTC for $2,000 more than the market price. If BTC is trading over $10,000, he will simply let his option expire.
Adam, like Robbie, will have to pay the premium to buy this option, and the premium is also the highest price he is willing to gamble in this deal.
In the other hand, we have option sellers or contract authors who are Robbie who Adam’s counterparties and have decided to market them call and put options, respectively. In return for the premiums charged by Robbie and Adam, these dealers are effectively agreeing to sell and purchase BTC on sale.
In terms of risk, the options seller’s benefit is constrained by the premium they charge, but their risks are theoretically unrestricted, and if the option is exercised, they must purchase or sell BTC regardless of how high the gap between the spot price and the strike price is.
This can be further explained via the OKEx Bitcoin Options Market view below.
OKEx BTCUSD200925 Options. Source: OKEx.com
The table above depicts call and put options for an expiry date of September 25, 2020. The blue circle denotes options contracts with a strike price of $11,000, which means that the owners of a call option for this contract will be able to purchase Bitcoin at that price on September 25, while the holder of a put option will be able to sell it at that price. The green and red circles represent the average premiums for call and put options.
If Robbie purchased this call option today, he will pay a premium of $1,355.10 to reserve the right to buy Bitcoin at $11,000 on September 25. Similarly, Adam will pay $2,678.28 to purchase his put option to sell Bitcoin at $11,000 on September 25.
The disparity in premiums reflects investor opinion, with the counterparty deciding to purchase Adam’s Bitcoin believing it is a riskier bet than the counterparty agreeing to sell to Robbie.
Another dataset that can expose the market’s outlook at a glance is Open Interest by Strike, as seen in the chart below.
BTC Options Open Interest by Strike. Source: Skew.com
The value (in BTC) of unexpired options (call + put) at different strike prices is depicted in this table. Which can be seen above, the majority of market participants have options contracts with a strike price of $10,125, followed by $7,250 and $11,250. Looking at this data reveals the three most popular strike rates as Bitcoin prices in play — as well as predicted levels in the foreseeable future.
Why do people buy and sell BTC via options contracts?
Options contracts, like futures contracts, are risk control tools, but they are more versatile because they do not impose any commitments on investors.
We should revisit Bitcoin miners as possible winners of these contracts, where they can buy put options to lock in a certain price for their mined BTC in the future. In contrast to futures contracts, where miners are obligated to sell their BTC regardless of interest, miners may opt not to sell if Bitcoin increases dramatically.
Another explanation for the use of options is speculation, since they encourage cautious market players to make bets for far lower amounts at risk (the premiums) than futures contracts.
Bitcoin Derivatives and legitimacy
Futures and options, for example, help the underlying asset’s price discovery — the market’s calculation of price — by providing the market with the means it needs to convey opinion. For example, in the absence of derivatives, Bitcoin buyers were largely limited to purchasing and owning the asset itself, resulting in a bubble in 2017 as prices skyrocketed to all-time highs.
The bear shorts were only able to pop the bubble after CME and Cboe released Bitcoin futures.
As much as the resulting downturn and “crypto winter” of 2018 harmed the industry, it also encouraged maturity and development as markets levelled out, enabling innovations and adoption to once again be at the forefront.
Meanwhile, the introduction of controlled derivatives like Bitcoin Options by Bakkt is helping to legitimise the crypto space and draw institutional investors.
Many claim that for Bitcoin to become a generally recognised asset class, it requires an open market that is difficult to exploit.
To do this, new money must be brought in, liquidity must be boosted, uncertainty must be minimised, organic price formation must occur, and large-scale institutional investors must be trusted. Any high-quality derivative product has the ability to bring Bitcoin one step closer to this level of legitimacy.
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