Did you know that, according to TechJury, the market capitalization of Bitcoin as of February 21st, 2021, was $1072.21 billion? Additionally, the highest number of daily Bitcoin transactions that were global in the first quarter of 2021 was 367,536.
Considering these numbers, it’s no surprise that so many people are interested in the Bitcoin market.
If you’re one of these many people, something you might be wondering about is how a Bitcoin’s future price is determined. Not knowing this can be stressful, especially given how confusing trading Bitcoin can be if you’re new to it.
Fortunately, in this article, we’ll review everything you need to know about Bitcoin futures and how they’re priced.
Finally, you can understand how Bitcoin futures are priced and start investing in this cryptocurrency. Before you know it, you’ll be making money from Bitcoin.
You might not be as rich as Bill Gates, but you’ll be more in control of your Bitcoin investing with what you learn from this article. Read on to learn more.
How Bitcoin Futures Came About
Before we go into how Bitcoin futures prices are determined, we’ll review the history of Bitcoin futures. This way, you can have a better idea of exactly what you’d be doing when you start investing in Bitcoin.
Specifically, you would have a better understanding of the way Bitcoin markets move.
When Bitcoin first appeared in 2009, many people weren’t sure about what would happen with this cryptocurrency. At this time, the trading of Bitcoin occurred on an exchange that was decentralized.
Because it’s such a new type of currency
Many governments don’t regulate Bitcoin exchanges. As a result, many traditional financial institutions aren’t able to facilitate transactions. However, despite all these complications, Bitcoin has gained a significant amount of value. So people have to come up with ways to get involved in the Bitcoin market.
This is where Bitcoin futures contracts come in. People started trading these contracts back in December 2017. Since then, they’ve gained a large amount of traction.
They make it possible for investors to have exposure in the same way they would with a commodity. However, they don’t need to hold the cryptocurrency that underlies the future.
The result of this is that these Bitcoin futures contracts come with hedging and risk mitigation possibilities.
The Bitcoin Futures Basics
Before we go into how Bitcoin futures prices are determined, it’s also important to review the basics of this type of cryptocurrency future. This way, you can understand how these contracts work. This will make it easier for you to decide whether this is a type of futures contract that interests you.
When it comes to Bitcoin futures, the trades of these occur on the CME or Chicago Mercantile Exchange.
This exchange will offer, for cash settlement, monthly contracts. But how does this work, exactly?
This means that if you were to invest, you would have the option to get cash when the contract settlement occurs. This is as opposed to the option of a Bitcoin physical delivery.
Investors who are interested in Bitcoin futures can choose a broker to go through to get involved. Some examples of these brokers include Interactive Brokers, TD Ameritrade, and Forex.com.
Every month, the Chicago Mercantile Exchange introduces new Bitcoin contracts. Six months is the amount of time that these Bitcoin futures contracts will be listed.
There are also an additional two December contract months. This is when the market makers set, for these contracts, an initial price. Then, momentum increases.
As this occurs, the mechanism of supply-demand will take precedence. This is what will then determine the Bitcoin futures price.
Determining Bitcoin Future Price
When it comes to how a futures contract derives its value, it comes from its respective underlying security. As for Bitcoin futures prices, these depend on the spot prices of the currency. But what do we mean by spot prices, exactly?
The spot price of Bitcoin is the current price within the market, at which someone can purchase or sell Bitcoin (with immediate delivery).
If there’s any movement at all in the spot price, there will be an effect on the Bitcoin future price. This relationship means that these two prices move with each other in sync.
There is a formula that’s theoretical that one can use to calculate the price of futures based on the spot price. With this formula, the future price is equal to the following:
- Spot price* (1 + rf – d)
It’s important to note what each of the terms in this means when plugging different numbers into the formula so you can determine a Bitcoin future’s price. When it comes to the term “rf,” this means risk-free rate (on the basis that it’s annual). As for “d,” this means “dividend.”
Note, too, that it’s also necessary to customize this formula for two particular Bitcoin points. The first thing you need to do is to make a change to the risk-free rate. It should be daily instead of annually.
The second thing you need to do is to make a change to the formula because there isn’t a dividend in Bitcoin cases. As a result, the adapted formula will look a bit different. With this new formula, the fortune price is equal to the following:
- Bitcoin spot price* [1 + rf* (x / 365)]
Note that, to be able to use this formula, you need to put in the right number to replace “x,” which we haven’t yet covered. When you’re using this formula, then, be aware that “x” is the number of days until the expiry.
The Importance of the Cost of Carry Concept
The cost of carry concept is important to understand when using the above formula. This is because the above formula for calculating the prices of futures of Bitcoin is based on the cost of carry concept. So, what do we mean by this?
Whenever someone who has money is investing in the futures type of contract, they also can invest in bonds. These are secured bonds. This is so that they can earn a rate of return that’s risk-free and the minimum available.
For this reason, the formula has a provision for return computing. These must be at par (at least) with the rate over time that is risk-free until the expiration of the contract.
In the case where there is no arbitrage chance, the price of futures is the sum of the cost of carry and the spot price. The formula reflects this.
Now, we’ll verify all this against historical and recent values. As of April 2018, the spot price of Bitcoin was $8,171, with the rate value that was risk-free being 2.25%.
According to what we’ve reviewed, then, the price of the futures, which would be expiring in that same month of April, would have been about $8,175.30.
This value, which has been calculated theoretically, is quite close to the price that the actual contract on that date closed. This actual price was $8,180.
But you may have noticed that there’s a slight difference here of around $5. You may be wondering, “How does one account for this?”
This difference is attributed to two things. One of these is brokerage charges. The other is the perception of volatility in the market.
These have the potential to shift, by points that are few, the real payout.
Real-World Bitcoin Future Price Determination
All this said, when it comes to the price determination of Bitcoin futures in the real world, things are a bit different than what they might look like when making theoretical calculations. In the real world, Bitcoin futures have a tendency to have wild swings (in either direction).
The fact is, market volatility that’s perceived can cause the price of a Bitcoin future to be quite different than what one calculates using the formula.
Explaining These Price Differences
Since Bitcoin futures contracts prices should, in theory, follow spot prices closely, you might be wondering, “Why is it that these differences occur?” Well, sure, the theoretical formula works. However, this is only in an ideal case in which there isn’t arbitrage.
However, this formula doesn’t account for price arbitrage and real-world volatility perception. You can see this in the $5 difference mentioned in the previous section.
Why does this happen? This is because participants in the market perceive the potential impacts volatility might have and include them.
Seeing how this works can help. So, let’s say that the days to expiry are two.
In this case, the calculation formula for futures prices would tell us simply that the Bitcoin futures contract’s price would remain quite close because of the amount of time that remains to the spot price it has.
However, due to high volatility, the spot price could shoot down or up significantly. This could occur within hours.
Additionally, there’s the chance of big events occurring. For example, consider a cryptocurrency ban.
Events such as this one can impact the perception market participants have when it comes to the near term. The spot price then reflects this.
Something else that impacts how volatile Bitcoin’s future prices are is the fact the market trades 24/7.
This means that volatility can occur fast. After a local event has happened, it can occur within hours. It can also occur within minutes.
This can occur even when the futures market might only remain open for some hours that are specified.
So, for example, if an event occurs overnight, it could have a big impact overnight on the spot price. As a result, the closing price could be quite different from the next day’s price.
What Does This Mean for Investors?
All this information means a few things. First of all, it means that the price discovery mechanism has inconsistencies. Additionally, it means that the impact of volatility on futures pricing has a large variance. Future trading is still a high-stakes game.
If you add in the fact that spot price trading occurs 24/7, then valuing futures becomes even more complex.
Despite all this, however, there is still quite a lot of interest in trading Bitcoin futures. After all, the uncertainty and volatility can allow for profitable opportunities, too.
However, cryptocurrency investing can be a risky venture. For this reason, it’s important to work with a professional who knows about market influences and volatility.
If you still choose to trade, then you should become as informed as possible so that you trade wisely. For example, you can pay attention to events in the cryptocurrency world and use the right strategies for trading.
Additionally, if you’re just starting, we recommend you start with smaller amounts. You should also ensure that, if you lose money, you won’t end up in a bad financial situation.
Even though it may take some time, this will be a better way of investing and trading Bitcoin futures.
Need More Information?
Now that you’ve learned about how to determine a Bitcoin’s future price, you might need more information. For example, you might want to learn more about trading strategies, or you want help figuring out which trading brokers to work with.
Whatever information you need, we can help. At Byte Federal, we’re experts when it comes to Bitcoin and Bitcoin futures.
Additionally, we have Bitcoin ATMs all over the country. If you’re interested in using one, look for one now.