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12 Lessons Before You Trade Bitcoin Futures

Kevin Cook
Ameriprise (AMP) delivered earnings and revenue surprises of 3.60% and 3.30%, respectively, for the quarter ended September 2018. Do the numbers hold clues to what lies ahead for the stock?
  • (0:45) - Bitcoin Surges Over $12,000... then $13K
  • (5:10) - 6 Starter Insights to Trade Bitcoin
  • (15:45) - How Will Large Futures Traders Impact Bitcoin?
  • (18:40) - What's Good About Futures Contracts?
  • (26:50) - The Crucial Function of the Clearing House
  • (30:10) - Contract Specs: CBOE & CME Bitcoin Designs
  • (36:00) - Futures Trading Can Be A Double-Edge Sword
  • (41:00) - Episode Roundup: Podcast@Zacks.com

Welcome back to Mind Over Money. I'm Kevin Cook, your field guide and story teller for the fascinating arena of behavioral economics.

And next to the historic stock market rally we are in the midst of, driven by exponential technology innovation, there is no greater economic story of behavior right now than Bitcoin.

Last night, the "OG" of cryptocurrencies made new highs above $12,000 and has been as high as $12,947 on GDAX, one of the popular trading exchanges.

Well, it looks like I need to update this already since I wrote it a few hours ago: just after 2pm ET, Bitcoin grabbed another $1,000 milestone above $13K.

The market cap of Bitcoin is now over $200 billion dollars and the average daily transaction volume has been over $6 billion dollars the past 3 days including Sunday. Today, Wednesday December 6, will probably set a new volume high record, or at least come in second vs the all-time high volume of over $11.5 billion dollars on Nov 29.

Even this past Saturday traded over $5 billion. Which brings up an interesting dynamic of this new market for an entirely new asset class: Saturday trading in a truly 24/7 market! Something I've never seen in my career as a trader and investor.

And this month, two established trading institutions here in Chicago -- CME Group CME and CBOE Holdings CBOE, which was formerly known as the Chicago Board Options Exchange before going public -- will be launching their own versions of Bitcoin futures as they respond to market demand from sophisticated, professional trading and investment institutions.

As I surf the message boards on Twitter and StockTwits, I see there is a lot of confusion and even fear about what Bitcoin futures will do to Bitcoin.

Since I traded futures for many years -- over 2 million currency contracts in my career as an FX market maker -- I have some insights that might help.


A Dozen Insights to Get You Started

Now let's jump right into my first 6 things you should know and begin to think about before you trade any Bitcoin or cryptocurrency product. Then we'll go deeper into the dynamics and mechanics of the futures contracts being offered by the two exchanges.

Note that I cover all of these in more detail in the podcast, but here's the basic list with a few notes for each...


Lesson #1: Bubble in Progress!

The "monetary revolution" that is Bitcoin has created a zeal for investing in it that can only be compared to the most manic gold rush of the 19th century. Plus, the ease of access on new private trading platforms and the "gurus galore" who talk about Bitcoin $50,000 or even $100,000 help fuel the speculation. (See last week's episode Bitcoin or CRISPR: Which is the Bigger Disruptor? where I describe some of those gurus.)


Lesson #2: No Charts Allowed!

In this mania, technical analysis is not very useful. We have a new asset class + rabid speculation + explosive momentum, volatility, and wild randomness. And all that equals charts out the window.


Lesson #3: Futures Are Great!

This is one of the topics I'm going to expand on in the second half of today's podcast. I will explain exactly how futures contracts work and why this innovation will be great for Bitcoin and the entire cryptocurrency space as they offer risk management, leverage, and centralized price discovery to large institutions who need to hedge or trade their exposure to Bitcoin.

And I'll dispel many of the worries that people have about the ultimate "decentralized" and unregulated digital currency being placed on a centralized, regulated trading venue.


Lesson #4: Futures Are a Double-Edged Sword!

This is the other topic I will expand on in more detail because if you've never traded futures before, a Bitcoin futures contract is probably not the best one to start with.

Of all the great things that Bitcoin futures will bring to this new asset class in terms of market structure, liquidity, risk management, price discovery and stability, it will also be a uniquely volatile product -- as you already know if you've been watching Bitcoin trade for the past month, or even just today!

Since futures use leverage and offer a more efficient use of capital, they are ideal for large hedgers (those with real economic risk exposure) and professional trading houses who can withstand the swings.

But for the small trader or investor, who might buy Bitcoin at $12K or $13K and still hold it if it goes back to $11K, this may not be possible with futures because of the contract size and leverage. We'll discuss those specific mechanics coming up.

By the way, as I type this at 6pm ET, Bitcoin has grabbed another milestone above $14,000!


Lesson #5: Coinbase is a Friendly Introduction

I opened a Coinbase account because I trusted their Silicon Valley-backed pedigree. While other exchanges have had problems with getting hacked, I thought maybe these guys had built better security. I consider this exchange a good "sandlot" to get your toes sandy.

Plus, you can trade very small percentage units like .01 Bitcoin if you wish. You can't do that with the fixed sizes of the coming futures contracts where the CBOE product will be based on 1.0 Bitcoin and the CME version will represent 5.0 Bitcoins.

So when you go to an exchange like Coinbase and spend $140 (.01 X $14,000) or even $14 (.001 X $14,000), that little bit of "skin in the game" will fuel your interest and due diligence to learn more.

As I have found, nothing inspires my due diligence like some real money skin in the game!


Lesson #6: Alt-Coins and ICOs Are Risky Business!

The cryptocurrency market is a true "wild west" of initial coin offerings (ICO), scams, and fancy YouTube ads for products you've never heard of. Two words: be careful. This area of investing requires lots of homework and due diligence. If you don't have several hours a week to put in here, your hard-earned money will probably be better off elsewhere.


What Are Futures For?

In the podcast, I go over the next 6 lessons about the purpose, dynamics, and mechanics of futures contract markets in detail. Here's the continuing list of topics...

Lesson #7: Economic Purpose of Futures Markets

Lesson #8: Risk Transfer & Price Discovery at Work

Lesson #9: Arbitrage as the Magnetic Force of Honest Pricing

Lesson #10: The Exchange Clearinghouse and FCMs Enforce Financial Performance

Lesson #11: Cash-Settlement Means No Coins to Lose or Get Hacked

Lesson #12: Contract Specs and the Mechanics of Trading with Leverage

In the podcast, I introduce some of the characteristics of the CBOE Holdings and CME Group products, but those links will take you directly to the exchange descriptions where you can learn about their different cash-settlement pricing systems and procedures.

For instance, CBOE Holdings is using a daily price auction from the Gemini trading exchange run by the Winklevoss twins whereas CME Group has helped create a real-time price index to track Bitcoin using the data from four exchanges.

Also in the podcast, I also offer a "bonus" insight from my long career as a trader and a trainer of traders...


Lesson #13: The Golden Rule of Trading

One element I don't feel I emphasized enough in the podcast is exactly how Lesson #10 works to protect all traders no matter how small, and thus preserve market integrity.

If you think of the Performance Bond required to trade a Bitcoin futures product as similar to a "security deposit" conferring the privilege to trade, and the proof you can cover your losses, what the exchange Clearing House does is guarantee all traders' performance on their long or short positions (i.e., you pay your losses or get paid your winnings) by using a "mark-to-market" system.

That system of continuous accounting throughout the day will make your futures brokerage account fluctuate accordingly. And if your account ever goes below a minimum threshold (called the "maintenance" Performance Bond) then your broker or FCM (Futures Commission Merchant) will require you to add funds, or your trades will be liquidated.

The FCMs are accountable to the Clearing House and gains/losses are settled every day so that no one ever loses money due to the losses of a counter-party. In this way, the self-regulating futures exchange system of strict accountability has "teeth" to enforce fairness and contract performance, no matter whether someone holds a futures contract for 3 minutes or 3 months.


Volatility and the Performance Bond

The exchanges will determine various initial Performance Bond (PB) requirements for different types of traders like hedgers, individual speculators, and institutional traders/market makers. Hedgers as you might imagine, may receive a lower PB because they actually deal in the underlying asset.

But those differences between types of traders are small compared to the real determinant of a privilege to trade Bitcoin -- its volatility. Normally, many futures and commodity markets will have annualized volatility (like the VIX) of 10% to 30%.

Bitcoin has daily volatility of 5-10% currently, which translates into annualized volatility of 80% to over 150%!

That means the Performance Bond requirement to trade a single contract could be anywhere from 25% (my first estimate last month) to 40%. And the brokers or FCMs get to decide how much higher than the exchange minimum they want on deposit.

And since the exchanges don't like to change PBs every week, they will run their volatility calculations to grasp some kind of expected average over the life of the contract, with a bias toward the extreme possible moves -- especially with a monster of volatility like Bitcoin!

Finally, here are my guesses for the Performance Bond of the contracts from the two exchanges (the official requirements will likely be released soon and/or are being communicated by the brokers/FCMs).

CBOE: 1 Bitcoin per contract should require somewhere between 25% and 40% of the contract value. For a $14,000 contract value, that could be between $3,500 and $5,600.

CME: 5 Bitcoins per contract would create a contract value of $70,000 and could require anywhere between $17,500 and $28,000 in initial deposit.

It will be very interesting to see how many large trading firms come to the table with their money starting Sunday December 10 with the launch of CBOE Bitcoin futures!

My next prediction, and my hope, is that Bitcoin futures trading actually reduces some of the volatility and helps the market mature with more institutions involved.

Note on stocks and investment disclosure: In the podcast, I talk about public companies that are and may continue to benefit from Bitcoin's growth as an asset class including NVIDIA NVDA, Amazon AMZN, and Square SQ. I own NVDA shares for the Zacks TAZR Trader portfolio.

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the TAZR Trader and Healthcare Innovators services.

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