How CME Group’s Bitcoin Futures Will Work

With CME Group expected to launch their Bitcoin futures market by the end of Q4, now would be a good time to learn how Bitcoin futures work

The US Commodity Futures Trading Commission (CFTC) confirmed Friday that CME Group and CBOE had met the requirements for regulated trading, while Cantor Exchange would also be able to debut Bitcoin binary options.

Futures contracts allow traders to speculate on the price of an asset without actually having to own the asset. The speculators profit by buying or selling a contract in anticipation of the asset’s price moving in a certain direction. In CME Group’s Bitcoin futures market--that they expect to have up and running by the end of Q4-each contract will represent five Bitcoins.

If a trader is selling their contract, they are called a short speculator, if a trader is buying a contract, they are called a long speculator.

Although there is often a minimum number of contracts that a trader must purchase, to keep this example simple, let's say Bob wants to buy one contract and the price is $50,000 ($10,000 per Bitcoin).

Before Bob owns the contract, Bob will need to deposit the initial margin.  The initial margin is often called a “good faith” deposit. Similar to a down-payment, a good faith deposit is a deposit into a trader’s account that shows that the trader intends to follow through with their contract. The initial margin is a percentage of the total contract that is often around five to 10 percent of the total contract. If Bob’s initial margin is 10 percent, Bob will own the contract after he deposits $5,000 into his trading account.

Now let’s assume Bob deposits $5,000 to buy the contract and is a long-speculator, meaning he believes/hopes Bitcoin price will rise above the spot price he paid for his contract--10,000 per Bitcoin.

CME Group has set the tick--the minimum price movement of the trading instrument--for their Bitcoin contracts at $5.00. This means that if Bitcoin price increases by $4, Bob  will not realize a gain/loss on his contract, because $4 is below the minimum tick. However, each time Bitcoin price increases by $5, Bob will gain/lose $25 on his contract (because each contract is composed of five Bitcoin)

The day after Bob Purchases his contract, let’s say Bitcoin price rises by $100 . Because Bob owns one contract,  the minimum tick is $5, and with each tick Bob earns $25, Bob will gain $500 on his contract (20*)(25)=$500.

On the other hand, if Bitcoin price declined by $100 during the trading day, Bob’s would lose $500 on his contract and Bob will see the funds in his trading account diminish.

Leverage

Keep in mind, Bob only paid $5,000 to become the owner of a contract worth $50,000. The $40,000 that Bob did not have to pay is borrowed money, in other words, Bob’s Bitcoin contract is leveraged. Because futures contracts are highly leveraged, investing in futures is considered very risky.

Now let’s imagine that after four weeks the Bitcoin index (price) increases by five percent or in other words, 500 index points. After four weeks, Bob has earned a profit of $5.00(500)=$2,500 viz. Bob has earned a 50 percent profit on his initial deposit. On the other hand, if the indexed declined by five percent Bob will lose $2,500, a 50 percent loss on his contract.

The more contracts a futures trader owns, the greater that trader’s risk. If the price decreases by a significant amount it is possible for Bob to lose even more money than he initially deposited for the initial margin.

Bob’s initial margin was 5,000 dollars, now instead of Bitcoin price rising by 100, let’s say Bitcoin price falls by $1,100, Bob’s account will be credited $5,500 at the end of the trading day. Now remember, Bob’s initial margin was $5,000. Because of his $5,500 dollar loss, he will be 500 dollars in debt to CME Group and will have to pay out of his own pocket to bring is trading account balance back to zero.

If Bob suffers a loss or a series of losses that deplete his initial margin to an amount lower than the maintenance margin--the lowest amount of money the broker allows Bob’s account to reach before requiring Bob to replenish his account-- Bob will receive a margin call from his broker, telling him to deposit the sufficient amount of funds to return him to the initial margin amount.

To mitigate some of the risk involved with Bitcoin’s volatility, the CME Group has placed price limits on Bitcoin Futures. Bitcoin futures will be subject to price fluctuation limits of seven percent, 13 percent, and 20 percent. When the price of a contract fluctuates +/- 7% to the prior settlement price--the price that Bitcoin was valued at when the market closed the previous trading day-- a  two minute monitoring period will begin where contracts will continue to trade, however, within the +/- 7% boundary. If at the end of that two minute monitoring period, the price is still at the limit down or limit up, a two minute halt on trading will begin. During the two-minute halt traders will be able to create market orders, however, they will not be fulfilled until the two minute halt period is over. Afterwards, the price limit will expand to 13 percent without a halt period and will be hard capped at 20 percent without a halt period. However, If the price fluctuates to 20 percent, trading for the rest of the day must occur within the +/- 20% limit.

CME Group’s Bitcoin Futures are currently pending regulatory approval, however, if approved, CME will be launching their futures before the end of Q4. CME’s decision to launch Bitcoin futures will most likely cause a number of big banks to keep their eye on Bitcoin. The CBOE has already discussed plans to launch a Bitcoin futures market, and Nasdaq expects to launch their Bitcoin futures market in the first half of 2018. It is likely that many institutional investors are going to be keeping an eye on CME to see how Bitcoin futures pan out.