Futures are a type of financial derivative that enables you to buy and sell based on what you think the price of an asset will be at some point in the future. They are a necessary feature of any maturing asset as a control of manipulation and volatility, and a means of hedging risk.
Futures have a practical advantage for commodity producers like farmers who want to lock in the profit from future production today – crops that are still in the ground. They want revenue now to reinvest and scale operation, and mitigate against the risks – like bad weather or blight – which might mean those crops never reach the market.
Contango in crypto may seem a million miles from growing wheat, but the principle is largely the same. There is both a perceived value/risk in owning Bitcoin today but also a perceived future value.
That value can be measured by the expectation of future price, say one year from now, being higher than it is today.
The risk is that the positive price expectation is wrong, and that price will have actually declined once a year has passed. There is also the risk you take in simply safely storing bitcoin and interacting with a counterparty to trade it.
Bitcoin contango isn’t free money, it works so long as price slopes up to the right over time.
What contango does is give you the option to hedge the future value against the risks associated with simply hodling. You won’t enjoy the benefit of any increase in price over time, but equally you are immune to any of the obvious risks that might cause price to fall.
You are essentially collecting a premium for owning bitcoin in a rising market. The last part of that sentence is crucial ‘in a rising market’. Bitcoin contango isn’t free money, it works so long as price slopes up to the right over time. Using an example from May 4th, 2021
- The price of Bitcoin right now is $56,465 (Spot)
- September Futures are pricing Bitcoin at $59,080
If you are considering Bitcoin today your options are:
- Buy & Hodl – hope price meets or exceeds what you paid at Spot
- Buy Spot & Sell the Future – Lock in a premium; you don’t care what happens
The table below illustrates the scenarios for price movement, which are exaggerated to make it easier to understand the mechanics.
The Buy Hodl option will take all the upside – if price goes up – but also includes risk of ruin, if price collapses all the way to zero.
The Contango option will lock in a premium of 5.25% no matter what happens.
The table is a simplification of how Futures work:
- It doesn’t include the cost of placing the contract itself.
- Futures contracts with exchanges like CME also have minimum value – there’s is equivalent to 5 BTC
- They are only offered for the next six months and two Decembers.
- They are cash settled. No Bitcoin ever changes hands
It is unlikely that a small investor would need or want to employ a tactic like Bitcoin but it is worthwhile to understand as the premium functions as a benchmark for the wider crypto ecosystem.
In essence it is saying, this is what people should be rewarded for holding Bitcoin until September whatever happens – based on the perception on May 4th, 2021.
This number should then make it easier to understand how passive interest rates within CEFI are derived. If you can theoretically make 5.25% – less the fees associated with buying the Future contract – the rest of the opportunities within the market are logically going to fall somewhere around this number.
The expansion of Bitcoin derivatives continually improves the process of price discovery, which is discussed in our section on how to trade crypto. CME for example added the option of trading Micro Bitcoin Futures in April 2021, greatly reducing the entry level from around $250k per contract to around $5,000 or one tenth of the price of Bitcoin.
The kind of Futures Contracts offered by CME are fixed term and cash settled at the same time each month, as they are regulated by the CFTC – Commodities and Futures Trading Commission. They aren’t, however, the only type of Bitcoin Future available.
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