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Cboe Bitcoin Futures: 5 Things You Should Know About XBT

Most retail traders stick to stocks, a smaller portion make their way into options, but very few trade futures. That could change when Cboe Global Markets (NASDAQ: CBOE) rolls out a bitcoin futures contract on Dec. 10, opening up a complex market to retail investors who see an opportunity to make large sums of money trading a volatile cryptocurrency with leverage on top.

Bitcoin is already red hot among retail risk takers. On any given day, the Bitcoin Investment Trust (NASDAQOTH: GBTC), which acts as a "bitcoin ETF" of sorts, ranks as one of the most popularly traded stocks at Fidelity, partly because its big daily price fluctuations are a boon to traders who stand to win or lose big in fast-moving markets.

Futures are likely to be popular among white-knuckle traders, thanks to their added leverage and the fact that speculators armed with small accounts can trade futures less expensively than they can trade stocks. TD Ameritrade, which has publicly declared it will allow its clients to trade bitcoin futures, prices futures trades at $2.50 per contract, whereas stock commissions are $6.95.

This could be a very big deal for brokers, futures exchanges, and, of course, bitcoin. Here's what you should know about the futures market, and Cboe's bitcoin futures (XBT) contract in particular.

1. How futures work

Futures contracts derive their name from the fact they are standardized contracts between two parties to buy or sell assets in the future. Through the futures market, a corn farmer could sell corn futures to a food producer to lock in the value of his upcoming harvest, for example.

In the case of bitcoin, futures serve mostly speculative purposes. The contracts will be cash settled, meaning that no bitcoin will change hands. Instead, at the time of the settlement date, the "loser" effectively pays the "winner" his or her gains.

An illustrative example may help explain how cash settled futures work. As I write this, one bitcoin sells for roughly $12,800. Someone who is bearish on bitcoin might sell one bitcoin futures contract that expires one month from today. A bitcoin bull who thinks the price will go up takes the other side of the contract.

On the settlement date one month later, we'll assume that bitcoin is worth $15,000. When the contract is settled in cash, the bullish investor would have made $2,200 ($15,000 less the $12,800 initial value of the contract) whereas the bearish investor would have lost $2,200. Futures contracts are a zero-sum game. For every dollar made by one market participant, another market participant must necessarily lose one dollar.

Image source: Getty Images.

2. One contract equals one bitcoin

Cboe's bitcoin futures (XBT) will represent ownership of one bitcoin. Thus, owning one XBT contract is economically equivalent to owning one bitcoin. Owning 50 XBT contracts is like owning 50 bitcoin.

With the click of a button, speculators will be able to profit on the ups and downs of bitcoin without any of the hassle of actually owning bitcoin.

Buying bitcoin is hard, and at times, impossible. Many exchanges have deposit and withdrawal limits, and some have had problems processing customer orders when market prices move quickly. Alternatives like Bitcoin Investment Trust charge lofty fees (2% of assets each year), and can trade at big premiums to the underlying value of the bitcoin they hold, making them unreliable proxies for bitcoin's actual market value.

In contrast, futures contracts can be bought and sold through an ordinary discount broker, just as stocks are bought and sold. If there's one thing to love about the Cboe bitcoin futures contract, it's that speculating on bitcoin will become much easier.

3. How the bitcoin price is determined

There are many bitcoin exchanges, and it isn't uncommon for prices to differ from one to another. The Gemini Exchange runs a daily auction for bitcoin at 4 p.m. and publishes its pricing data for public consumption, making it an easy reference point for Cboe bitcoin futures market participants.

In a recent auction on Dec.5, more than 40 bitcoins changed hands at a valuation of $11,811.865 each. If a futures contract were settled on that day, the $11,811.865 price would be used to determine the profit or loss for investors who held the contract at settlement.

Of course, futures contracts move up and down in value throughout the trading day, and investors are free to buy and sell them at any time the market is open. I expect that bitcoin futures nearing their settlement date will trade at a price that approximates the current price of bitcoin on Gemini's continuous exchange. Gemini's data show that 4 p.m. auction prices differ from live prices at 4 p.m. by less than 1%. 

4. Futures are leveraged instruments

One reason futures are popular is because they allow for the use of leverage, amplifying a speculator's gain or loss.

Based on a number of reports, the Cboe expects its bitcoin futures will have an initial margin requirement of 30%. Thus, investors will have to put up 30% of the contract value to make a trade. The table below shows the simplistic math behind margin requirements. 

Bitcoin futures price

Margin requirement

Required outlay

$12,800

30%

$3,840

Source: Author. Data is purely illustrative.

In effect, investors can use margin to multiply their buying power. Rather than pay $12,800 for one bitcoin outright, Cboe's bitcoin futures enable speculators to pony up as little as $3,840 for the same exposure to one bitcoin.

5. Not everyone is happy about bitcoin futures

The embedded leverage in futures trading worries some market participants and brokerage firms. Trades in bitcoin are almost entirely speculative, as there are few commercial applications for the digital currency. Furthermore, bitcoin is a very volatile asset even without leverage on top.

For its part, Cboe outlined instances in which it would institute brief trading halts as a sanity check for fast-moving markets. Trading would be halted for two minutes when prices rise or fall 10% from the previous day's auction price, and for five minutes when prices rise or fall 20%. But while Cboe can halt trading in futures, it has no control over spot markets for bitcoin, where transactions take place around the clock, every single day of the week.

Using data from CoinMarketCap.com going back to May 2013, I find that roughly once every two weeks, on average, bitcoin had a day where its daily high or low was 10% higher or lower than its price at market open. Short trading halts in bitcoin futures may be a relatively common affair.

Those who plan to use bitcoin futures to speculate on the digital currency should risk only what they'd be comfortable taking to Las Vegas. Most importantly, avoid taking positions so large that the value of your bitcoin futures exceeds the value of your brokerage account equity. Leveraged future trades are one of the very few ways you can lose all of your account balance, and more, if markets move against you.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool recommends Cboe Global Markets. The Motley Fool has a disclosure policy.

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