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How Are Bitcoin Futures Priced?

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Since Bitcoin futures were first introduced by the Chicago Mercantile Exchange (CME) back in 2018, there has been an explosion of Bitcoin futures exchanges. Today, exchanges like BitMEX and Bybit record billions of dollars in daily trading volume.

However, although Bitcoin futures are now in popular usage among traders, there still remains some misconceptions surrounding how they work, and how they are priced in particular.

With that in mind, we’ll explore the typical factors that contribute to Bitcoin futures prices, and how an understanding of this can be used to obtain near risk-free profits.

How is the Price of Bitcoin Futures Determined?

For the most part, Bitcoin futures trading platforms tend to issue contracts that expire and settle at some fixed date, usually 1-week, 1-month or 3-months in the future. At this date, the futures will be settled in the currency specified on the contract, such as the US dollar (USD) or a stablecoin.

When these contracts are initially launched, market makers set the price of the contracts and trading continues based on supply and demand. Since these futures contracts derive their value from the underlying asset—in this case, Bitcoin—they tend to move in sync with changes in the Bitcoin spot price.

As such, an increase in the Bitcoin spot price tends to increase the prices of the associated BTC futures, whereas a decrease in the spot price usually results in a concomitant fall in the contract’s price.

Theoretically, the price of futures relates to the underlying based on the following formula; Futures Price price = Spot price ∗ (1+rf−d), where rf is the risk-free rate on an annual basis, and d is the dividend.

However, a modified formula is required to derive the price of BTC futures, as follows; Bitcoin futures price = Bitcoin spot price * [1+rf*(x/365)], where x is the number of days until expiry. In essence, this simply changes the standard formula to remove the dividend and change the risk-free rate from an annual to a daily basis. For more on this, including a worked example, check out this.

With that said, it should be noted that some BTC futures are priced based on the Bitcoin reference rate, rather than the spot price. CME, one of the more popular places to trade Bitcoin futures summarizes how this rate is calculated in this short article.

With that said, it isn’t a perfect system. Because BTC markets are notoriously volatile and are often subject to significant moves based entirely on changing in trader sentiment, Bitcoin futures can be valued either higher or lower than predicted by the above formula.

In light of this, we will look at how this can affect the prices of futures in the next section.

Why do Bitcoin futures trade at a premium or discount to spot prices?

When trading Bitcoin futures, it’s important to be aware of the basic principles that govern their pricing and understand the different variables that contribute to the futures market structure.

Although Bitcoin futures tend to follow the direction of BTC spot price movements, the magnitude of this movement can differ between the two. As such, the price of BTC futures can fall below the spot price, or they can be trading at above the spot price.

In general, the latter is usually the case because of the way the interest rate is factored into the pricing of a Bitcoin futures contract. Since this interest rate is usually positive, the contract typically trades at a slight premium above the spot price.

Beyond this, there are two important concepts to be aware of, these are contango and backwardation—two terms used to describe the structure of a futures market’s forward curve. When the forward price of a Bitcoin future is higher than its spot price, this situation is known as contango, whereas if the price of Bitcoin on spot markets is higher than the futures, this is known as backwardation.

As these contracts move towards expiry, the futures price will eventually move to converge with the BTC spot price, gradually reducing the potential for arbitrage opportunities.

As we previously touched on, the BTC futures contract price is usually slightly higher than the spot rate—this is not to be confused with contango, which is described as an unusually high forward price compared to the spot price.

In general, a BTC futures contract will typically trade at a premium (in contango) during strong bull markets, when traders believe Bitcoin will be worth more in the future than it is currently. For example, if traders believe an upcoming event is likely to positively impact the value of Bitcoin in the future, they may be willing to pay a premium to secure their futures now.

On the contrary, traders that believe BTC will be worth even less in the future might look to sell their futures at a discount, leading to a backwardation situation where contracts are trading at lower than the Bitcoin spot price. This typically occurs during bear markets, where the outlook looks negative, such as following regulatory pressure or a high profile exchange hacking.

How to profit from futures premiums or discounts?

The fact that futures contracts frequently trade at premium or discount prices opens up several different opportunities that savvy traders can exploit to turn a profit with very little risk.

One of the simplest ways to turn a net profit from Bitcoin futures trading at a premium is to open what is known as a cash and carry trade. In brief, this involves buying BTC at its spot price, and selling its associated futures contract in order to lock in the futures premium as profit.

To do this, a trader would need to purchase BTC at the current spot price, and sell futures when there is a large positive delta (contango). If Bitcoin increases in value by the expiration date, then the spot position will cover any losses incurred by the short, whereas the opposite is true if its value decreases. In any case, the profit is practically guaranteed.

For example, if BTC is currently trading at $10,000 on the spot markets, but $12,000 for the 3-month futures contracts, this is equivalent to a delta of +20%. Purchasing 1 BTC at spot price and selling 1 BTC of these futures would yield a $2,000 profit when the futures settle. Since $12,000 earned from the futures sale – $10,000 spot costs = $2,000 net profit. This profit is locked-in regardless of how the Bitcoin spot price changes.

However, in order for this trade to be profitable, the Bitcoin premium needs to be high enough to cover the costs incurred by holding the futures contracts until the delivery date. During times of extreme Bitcoin volatility, the contract’s premium can be significant, which can lead to substantial profits with minimal risk.

Likewise, it is also possible to extract low-risk profits from the market when it is in backwardation, by essentially reversing the cash and carry trade to buy futures contracts that are undervalued and sell Bitcoin at current spot prices. Therefore, instead of buying BTC because it’s underpriced (as with a cash and carry trade), you sell it short because it’s overpriced—this is known as a reverse cash and carry trade.

For example, if BTC is currently trading at $12,000, but its futures contract is trading at $10,000, then you would short sell BTC on the spot market at $12,000, and use this money to buy Bitcoin futures at $10,000. Before the contracts expire, you would then accept delivery and use these funds to cover the short position.

All in all, your profit will be $2,000 (less fees). Because of this, the reverse cash and carry strategy can be used to turn a profit whenever a backwardation scenario with a sufficient negative delta appears.

Both the cash and carry, and the reverse cash and carry trade, can be done on exchanges like BitMEX, or most of its alternatives.

Conclusion: Pricing Bitcoin Futures

Overall, BTC futures contracts represent useful instruments for speculating on the direction of the market and for locking in low-risk profits by leveraging arbitrage opportunities against the Bitcoin spot price.

With that said, although it’s certainly possible to turn a profit with both cash and carry, and reverse cash and carry trades, traders do need to be aware of the potential risks involved. In particular, traders need to pay close attention to their carrying costs, since the brokerage firm or BTC futures trading platform can increase its margin rates, while those attempting to cash and carry trade on leverage will need to ensure they stay within the margin requirements.

Beyond this, during times of excessive volatility or low liquidity, it is possible for slippage to occur, potentially reducing your expected profits, whereas the potential to be caught up in socialized losses is there when trading on exchanges that use this system.

pascal thellmann

Pascal Thellmann is an algorithmic trader mostly focused on crypto breakout strategies. He started CoinDiligent to share his learnings and give paid access to some of his automated trading strategies. You can get in touch with Pascal on LinkedIn or Twitter.

Source: https://coindiligent.com/how-are-bitcoin-futures-priced

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