Investors need to be clear on three things before they look to trade Bitcoin futures

Russ Mould, investment director at AJ Bell, looks at three things investors need to consider before they trade Bitcoin futures:

“Few if any market participants thought that Bitcoin would get to a price just shy of $17,000 as quickly as it has (if at all), so it would be foolish to try and call the top, as such price surges have a habit of becoming self-fuelling and this could easily be the case this time, given plentiful global liquidity and the finite supply of Bitcoins.

“But before they pile in, potential Bitcoin-buyers or futures traders need to think about three things:

1.     “They need to be sure in their own minds what Bitcoin is.

“America regulates it as a currency, Korea regulates it as a commodity and the recent rampant price action suggests that a lot of people view it as an investment. Any would-be buyer or trader needs to make up their own mind so they can then assess whether the price movements and potential return fit with their overall portfolio strategy, target returns, time horizon and appetite for risk.

“Yet Bitcoin is not a commodity in the classic sense (even if you can now trade futures, just as you would for oil, aluminium, cotton or orange juice) because it has no physical form and does not help buyers produce or do something else (which is the case for hogs, industrial metals, energy or even gold and silver).

“It is not an investment because it generates no cash, so it cannot be valued in the manner of a security like a corporate bond or stock, which (when things go well) do generate cash and pay dividends or coupons.

“Its origins lie in the world of digital currencies and a hedge against central bank money printing but few people would feel comfortable going to a Bureau de Change if the pound was moving around by 10% to 20% a day or more.

2.     “They should note that cryptocurrency prices are almost all lower across the board now that the futures trading has begun.

“There is an old saying that markets “buy on the rumour and sell on the fact,” trying to anticipate an event and factor it into valuations and prices before it happens – so that when something does come to pass investors are already moving on to the next idea.

“Bitcoin futures have surged to an early premium to underlying Bitcoins, according to the CBOE and Coinmarketcap websites, at $16,715 and $19,100 (for March 2018) respectively, but the underlying asset still trades below Friday’s $18,302 peak.

“But it is also noticeable that all ten of the biggest cryptocurrencies by value are currently trading below last week’s highs and some of the drops are very sharp. This may give some investors cause to wonder whether the market has already “bought on the rumour and sold on the fact”, although such a theory could be confounded if the leading cryptos were to move higher and sustainably forge new price highs.”

Source: Coinmarketcap.com

3.     Innovative products (especially derivative ones) tend to appear a lot nearer the top in prices than the bottom.

All investors need to do here is think of the ABX Index. This was created as a synthetic instrument so it was possible to trade the sub-prime mortgage market in America, via five baskets of varying quality of mortgage loans. The index was launched in January 2006, barely a year before the sub-prime mortgage market collapsed and the Great Financial Crisis began.

Under such circumstances it may be worth bearing in mind legendary US investor Warren Buffett’s comments in his Letter to Shareholders from 2000 (just before the tech bubble burst) on the providers of innovative financial instruments and investors eager to get involved with the latest trend:

“A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street — a community in which quality control is not prized — will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.”

“None of this is to say the Bitcoin game is over. But all three considerations suggest would-be traders or investors need to move with greater caution than the initial futures market action would suggest they are today.”

APPENDIX: How futures contracts work

• A futures contract is a two-way deal between a buyer and seller, whereby they agree to exchange an asset for cash in a pre-set quantity, for a pre-set price on a pre-set date in the future.

• Futures contracts are in essence a derivative because they derive their value from the movements in the price of the underlying asset. They are not traded on exchange but off-exchange in so-called over the counter (OTC) deals.

• Futures are usually traded “on margin.” Since there is a risk that either the buyer or the seller tries to welsh on the agreement if it starts to go against them, both may be obliged to lodge a percentage of their financial commitment (or margin) with trusted and financially sound third party, known as a clearing house. This also means that traders can get involved using only a fraction of the financial outlay that would be required to acquire the underlying asset. This is good when the price goes the ‘right’ way but can be bad if it goes the ‘wrong’ way – the clearing house can request more margin as security and if the losing party does not have it, they may become a forced seller, triggering a downward price movement which in itself leads to more margin calls, forcing further selling of futures positions.

• Futures can be settled with delivery of the underlying asset but in the case of Bitcoin they are likely to be cash-settled, using the market price of Bitcoin as a reference point. The buyer and seller will settle by paying or receiving the cash gain or loss upon expiry of the futures contract.

• In the case of Bitcoin, there is no physical asset involved and supply is fixed so it will not be possible (or at least very difficult) for futures traders to manage any liabilities or exposure they have via the cryptocurrency (unlike with a stock index, bond index or commodity where the trader can buy or sell the underlying stocks or bonds or raw materials to manage their position, via what is known as arbitrage). In this case the price on expiry will be set by supply and demand for Bitcoins at a set date in the future, something that in turn is likely to be determined by investor sentiment and enthusiasm (abundant or absent).

• When a futures price is trading above the current (or spot) market price, the asset is described as being in “contango.”

• When a futures price is trading BELOW the current (or spot) market price, the asset is described as being in “backwardation.”