5 Things You Should Know About CME Bitcoin Futures

Forget about the sort-of bitcoin ETF Bitcoin Investment Trust (GBTC 3.40%). Futures could become the newest and best way to bet on bitcoin.

Sunday's launch of Cboe Global Markets' bitcoin futures were just the opening act. When CME Group launches its bitcoin futures contract on the largest futures exchange in the world on December 18, it'll be a very big deal for the futures markets, brokerage firms, and of course, bitcoin.

Here's everything you need to know about how these futures will work, and which brokers will actually let you trade bitcoin futures in your brokerage account.

1. How futures work

If we're being frank with one another, futures are just a socially accepted (and legal!) way to gamble on the future price of all kinds of things -- corn, utility stocks, interest rates, the S&P 500, and now, bitcoin. We can spare the financial jargon. I'll explain how futures work with an illustrative example where you and a coworker bet on the future price of bitcoin. Here goes.

One bitcoin currently trades for $16,000. You think it will be worth more in the future. Your friend Bob thinks it will be worth less. Annoyed with your endless tirades about bitcoin, Bob tells you to put your money where your mouth is, drawing up a bet based on bitcoin's price three months from today.

If bitcoin goes up, Bob will pay you an amount equal to its gains. If it goes down, you'll pay Bob for how much it drops. You're "long" bitcoin, and thus you make money if it goes up. Bob's "short" bitcoin, and thus he makes money if it goes down.

Three months pass, and it's time to settle the bet. You and Bob log online and see that bitcoin is trading for $18,000. You won the bet, and Bob pays you $2,000, or the difference between the current price ($18,000) and the price at which you commenced the wager ($16,000). And just like that, Bob and you have basically made your own little futures market without even knowing it. Futures really are that simple.

You can think of futures contracts as nothing more than a side bet between two people with opposing views. Bitcoin contracts are settled in cash, with the "loser" paying the "winner" his or her profits.

You don't have to own bitcoin. You don't have to buy bitcoin on a sketchy online exchange. No bitcoin even changes hands during any of the process. You just have to find someone else to take the other side of a bet. The futures market makes finding someone to take the other side of your wager as easy as clicking a button.

Unlike many financial markets, futures are a zero-sum game. For every person who is long bitcoin, someone else must take the opposite side and be short bitcoin. For someone to make a dollar in futures, someone else must necessarily lose a dollar. It's basically online gambling, legal in all 50 states, and best of all, money you make in the futures market is generally treated better by the Internal Revenue Service (IRS) than money you make betting on college basketball.

2. Bitcoin futures are leveraged

Speculators love futures because they allow for the use of leverage to multiply their gains or losses when prices rise or fall. 

The CME Group anticipates that its bitcoin futures will be subject to a margin requirement of 43%, meaning you only have to put up 43% of the value of the underlying bitcoin to buy or sell a futures contract. (Note: Your broker may have different -- higher -- margin requirements.)

As I write this, one bitcoin trades for approximately $16,000. A hypothetical CME bitcoin futures contract would have a notional value of about $80,000 (five bitcoin per contract multiplied by the market price of $16,000). Therefore, investors would only have to pony up about $34,400 of their own money to profit on the gain or loss on five bitcoin worth $80,000.

Source: Hypothetical example designed by author. Margin requirements sourced from CME Group.

From a speculator's standpoint, leverage is a key feature of the futures market. With $34,400 of cash, you could afford to buy a little over two bitcoin on a bitcoin exchange. However, through the futures market, $34,400 would enable you to profit on the ups and downs of five bitcoin.

It may help to think about this in percentage terms. If you only pony up 43% of the value of the underlying bitcoin, every 1 percentage-point change in the price of bitcoin would result in a 2.33 percentage-point gain or loss on the margin you put up to open the trade. (100/43 = ~2.33)

3. How bitcoin futures will trade

CME Group's bitcoin futures will likely trade at a value that approximates the current market price of the cryptocurrency on online exchanges multiplied by five. CME Group has its own Bitcoin Real Time Index (BRTI) to use as a guide for what bitcoin are worth at any given time.

The price index is updated every minute on the CME Group website, where it writes that the index is "suitable for marking portfolios, executing intraday bitcoin transactions and risk management." Simply said, CME's bitcoin futures should trade for roughly five times the current Bitcoin Real Time Index, as calculated by CME. 

When it comes to the official settlement -- the name for the time at which gains or losses are officially tallied -- CME will use a different index it calls the Bitcoin Reference Rate (BRR) to determine the official value for its futures contracts.

One of the most basic problems standing in the way of cryptocurrency-based investment vehicles is that online bitcoin exchanges aren't very deep. In theory, a market manipulator could accumulate a supersized, $10 million futures bet that bitcoin will rise in value. Just before the contract settles, the market manipulator could rush to an online bitcoin exchange and buy $2 million of bitcoin, pushing up the price. He might lose 2%-3% on the $2 million buy due to fees and sloppy trading, but it's worth losing 2%-3% on $2 million if it nets a 2%-3% gain on a $10 million futures position.

The Bitcoin Reference Rate is designed to make this kind of market manipulation more difficult, even if not entirely impossible. In simple terms, the Bitcoin Reference Rate is a price for bitcoin based on the "average" bitcoin price on multiple exchanges over the course of an hour. Manipulating the price of bitcoin for a single second or minute is relatively easy. Doing it for an hour would be very hard to do. 

If you're especially curious about the official methodology used to calculate the Bitcoin Reference Rate, I explain it in the paragraph below. Otherwise, scroll on to the next header in the article. 

Source: Getty Images.

The actual methodology used to calculate the Bitcoin Reference Rate is as follows: Trades on bitcoin exchanges Bitstamp, GDAX, itBit, and Kraken are logged from 3:00 p.m. to 4:00 p.m. London time (10:00 a.m. to 11 a.m. EST). The trades that occur during this hour are segmented into 12 time intervals of five minutes each. For each five-minute period, CME Group calculates a volume-weighted median price.

The 12 median prices from each five-minute period are then averaged, resulting in the Bitcoin Reference Rate used to value bitcoin futures at settlement. All this is relatively unimportant when the futures are actively trading, since during those times (most of the day), prices are more likely to follow the simpler Bitcoin Real Time Index.

4. CME Group's bitcoin futures will likely eclipse Cboe's

Cboe made a lot of noise when it launched its bitcoin futures contracts. So far, though, trading volume has been relatively light. Launched on Sunday, only 4,127 Cboe contracts traded hands by the end of trading on Monday.

Cboe isn't a big player in futures. You might surmise that from its name, which is derived from "Chicago Board Options Exchange." Options, not futures, are Cboe Global Markets' bread and butter. In contrast, the CME is generally regarded as the futures exchange, as it is the largest in the world. Some brokers, like Ally Invest, have even specifically said they're waiting on the sidelines for the CME Group contracts to launch, passing on the Cboe's contracts.

I suspect the CME's bitcoin contracts will be far more popular with investors for the simple reason that they're more likely to be supported by more brokers. In addition, commissions on CME's futures may be lower as a percentage of notional value than Cboe's. CME Group's futures contracts represent ownership of five bitcoin, whereas Cboe's futures represent ownership of one bitcoin, an important difference since commissions are often priced on a per-contract basis.

If you wanted to get exposure to 50 bitcoin through Interactive Brokers (IBKR 1.41%), the only broker to publish a price list for both futures contracts, you'd have to trade 50 Cboe contracts and pay a commission of $5 per contract, or $250 in total. To get the same exposure with CME bitcoin futures, you'd only have to trade 10 contracts, paying $10 per contract in commissions, or $100 in total.

5. Will your broker offer bitcoin futures?

Most brokers aren't ready to bring bitcoin futures to their clients, but it's expected that more brokers will hop on the bitcoin train over time. 

Interactive Brokers has already opened up Cboe bitcoin futures for trading and will allow its clients to dabble in CME Group's bitcoin futures, too. For now, you can only go long bitcoin futures, but the discount broker announced it will soon enable its clients to short bitcoin futures.

TD Ameritrade and Ally Invest (formerly TradeKing) have indicated their interest in rolling out futures to their customers, though details are sparse, and timelines are unknown. More than 40% of trades placed on TD Ameritrade are for financial derivatives like futures, so it seems like a natural fit for adding bitcoin futures relatively quickly. 

Charles Schwab and E*TRADE may add the products, but only after seeing how the market develops. By all reports, Fidelity isn't interested in bitcoin futures, which is interesting considering that the sort-of bitcoin ETF, Bitcoin Investment Trust, often appears as one of the most actively traded stocks on its platform. If you want to trade bitcoin futures right now, Interactive Brokers is the only game in town. 

Blame bitcoin's volatility for brokers' hesitation. Futures are inherently risky for brokerages because speculators who use leverage can lose all of their account balance and more if the market goes against them. When that happens, brokerages have to become debt collectors, and what they can't collect from their money-losing clients they have to eat as a loss. 

The CME Group has limits on how much a futures contract can move on any one day. A 7% move may result in a two-minute trading halt. It strictly forbids trading at any prices 20% higher or lower than where the contract opened for the day.

Of course, CME Group only has power over its exchanges. Bitcoin can trade freely on online exchanges where there aren't any real rules to govern price fluctuations. I count 27 times in which bitcoin traded 20% above or below the opening price, using data from CoinMarketCap.com going back to May 2013.

On its best day in the data set, bitcoin rocketed by 42%. On its worst day, it plunged by 38%. Brokerages are smart to tread carefully. Speculators should tread carefully, too.