How Are Bitcoin Futures Priced?

What Are Bitcoin Futures?

When Bitcoin first hit the market in 2009, no one was really sure where it would go, let alone whether the buzz would last. Because it was traded on a decentralized exchange, authorities thought this digital currency would lead to illegal transactions, money laundering, and even terrorist financing. But the market has come a long way since then.

The value of and interest in this cryptocurrency has exploded exponentially. Trading takes place on exchanges or through sites that allow peer-to-peer transactions. Bitcoin isn't regulated by most governments, which means financial institutions can't facilitate transactions. Its popularity has led to the development of other forms of digital money and other ways to trade Bitcoin.

Market participants can now trade Bitcoin futures contracts. These futures contracts were launched in December 2017 and have gained a lot of traction since then. They give investors exposure the same way they would to a commodity without the need to hold the underlying cryptocurrency. As such, Bitcoin futures contracts also offer risk mitigation and hedging possibilities. If you're interested in learning more about these contracts, keep reading. This article looks at how Bitcoin futures contracts are priced.

The Basics of Bitcoin Futures

Before we look at how Bitcoin futures are priced, it's important to note some of the basics of these contracts.

Bitcoin futures contracts trade on the Chicago Mercantile Exchange (CME), which offers monthly contracts for cash settlement. This means an investor can take cash rather than physical delivery of Bitcoin upon settlement of the contract. Interested investors can go through a broker, such as Forex.com, TD Ameritrade, and Interactive Brokers, to get in on the action.

The CME introduces new Bitcoin contracts every month. These contracts are listed for six months. The exchange also lists two more December contract months. Trading begins when market makers set an initial price for these contracts. As momentum increases, the supply-demand mechanism takes precedence to determine the price of the futures.

Determining the Price of Bitcoin Futures

All futures contracts derive their value from their respective underlying security. Bitcoin futures prices depend on the currency's spot prices. This is the market's current price at which Bitcoin can be purchased or sold for immediate delivery. Any move in the latter affects the former. This relationship leads to the prices of the two moving in sync with each other, though there is a difference between the two.

Calculating Bitcoin Futures

The theoretical formula for calculating the futures price from the spot price is as follows:

$\mathbf{\textbf{Futures Price}=\text{Spot price }^*(1+r_f-d)}$Futures Price=Spot price ∗(1+rf​−d)

where, r_f = risk-free rate on an annual basis, and d = dividend

This formula needs customization for two points that are particular to Bitcoin. The first is the change for risk-free rate from an annual to a daily basis, and the second point refers to the fact that there is no dividend in cases of Bitcoin so ‘d’ can be removed.

$\begin{aligned}&\textbf{Bitcoin Futures Price}\\&\qquad\mathbf{=}\textbf{Bitcoin Spot price}\mathbf{^*\left[1+r^*_f\left(\frac{x}{365}\right)\right]}\end{aligned}$​Bitcoin Futures Price=Bitcoin Spot price∗[1+rf∗​(365x​)]​

where x = number of days to expiry

The Cost of Carry

The formula is based on the concept of cost of carry. Anyone with money investing in a futures contract can also invest it in secure bonds to earn the minimum available risk-free rate of return. Hence, the formula includes a provision for computing the returns, which are at least at par with the risk-free rate over time until the contract expires. If there is no chance of arbitrage, the futures price is the sum of the spot price and the cost of carry, which is reflected in the formula.

Let’s verify this against recent historical values. With the risk-free rate value of 2.25%, Bitcoin's spot price of $8,171 as of April 18, 2018, the futures price expiring in April comes to around $8,175.30. This theoretically calculated value is very close to the actual price of $8,180 at which the contract was closed on that date.

So how do we account for that slight difference of about $5? This is attributed to brokerage charges and the market perception of volatility, which could shift the real payout by a few points.

Real-World Price Determination

Beyond any theoretical calculations, the price of Bitcoin futures in the real world tends to run with wild swings in either direction. To understand the randomness in the price discovery mechanism of futures, let’s look at how prices of these futures contracts have behaved in the recent past:

The graph above shows the price of Bitcoin in blue (the spot price), the price of futures contracts expiring in April in green, and the price of a Bitcoin futures contract expiring in May in red. We can make a few key observations from the information in the graph.:

• The price of futures may come close to the spot price (Arrow 1)
• The price of futures may jump higher than the spot price (Arrows 2 and 3)
• The price of futures may fall below the spot price (Arrow 4)

But why does this happen? This is due to the relative differences between the blue graph, or the spot price, and the green and red graphs, or the future prices, at the marked locations.

Explaining the Price Differences

Since futures contracts are believed to closely follow spot prices, you're probably wondering why these differences occur. While the theoretical formula is good for the ideal case without arbitrage, it doesn't account for the real-world perception of volatility and price arbitrage. The same is reflected in the $5 difference we noted in the previous section.

This happens because market participants perceive and include the possible impacts of volatility. If there are only two days to expiry, the futures price calculation formula simply tells us that the price of the Bitcoin futures contract will remain very close to its spot price because of the time remaining.

But its spot price may shoot up or down significantly within hours because of high volatility. Big events may also occur like a ban on cryptocurrencies. Events like this can impact market participants' perception for the near term, which is reflected in the spot price.

Bitcoin trades 24/7, which may mean its spot prices are prone to high volatility within hours—even minutes—based on local developments, while the futures market may remain open only for a specified number of hours. It's possible that the futures price closed near the spot price one day but a significant development spiked Bitcoin's spot price by 12% overnight, meaning investors can expect a wider gap when futures open the next day.

The Bottom Line

Despite the inconsistencies in the price discovery mechanism and the large variance of volatility impact on futures pricing, futures trading remains a high-stakes game. Combining it with the 24/7 trading in spot prices adds another layer of complexity to valuing futures. Nevertheless, bitcoin futures trading continues to draw interest as this volatility and uncertainty also allows for profitable opportunities.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.