As widely reported, Cboe launched trading of Bitcoin futures on December 10 2016. Future instruments make it possible to go short, a good trade if you expect the price of Bitcoin to fall.
— Cboe (@CBOE) December 11, 2017
But other exciting trading opportunities are opened up by the new futures. To get an idea of what's possible we look at well-established futures markets such as those in commodities or FX. In these markets, it's common to trade strategies that combine futures and the underlying to exploit arbitrage or trade a particular market view.>
We start by looking at one classic strategy, the ‘Cash-And-Carry Trade' to see if it is applicable in the current Bitcoin market.>
The idea is simple; if the future is trading above the underlying asset (Bitcoin) today, we buy the asset and sell the future, thus receiving cash and locking in a profit. Then on the delivery date, we sell the bitcoin to cover the costs of settling the futures contract. For the deal to be profitable, the price difference has to be large enough to cover interest between today and the delivery date as well as all costs fees.
In theory and assuming a perfect market, this would allow us to lock in a risk-free profit, making arbitrage. However, in practice, there are many costs, risk factors and margin requirements that can make the strategy impractical even if the numbers look good initially.
Looking at the current Bitcoin market, we can see some potential for profitable trades although it is decreasing daily. With the calculator below you can explore how it works and see how fee/risk levels impact potential profitability.
A closer look at the risks
In some scenarios it looks like we could lock in profit even taking fees into account - so why isn't everyone doing this?
The fees do have a significant impact, but the primary challenge in this trade are the many risks, some non-obvious. First, all the risks associated with cryptocurrencies such as lack of liquidity and hacking threats. But then a less visible but severe problem is slippage risk caused by the strategy containing multiple trades.
Slippage is when the actual price we execute at is different from what we expect. In this case, a perfect market would let us sell the bitcoin and settle the future at precisely the same time and price. But in practice, market imperfections and Bitcoin volatility could lead to the price moving between the two trades, wiping out profits or putting you in the red.
As Bitcoin continues to mature we expect more sophisticated instruments to be launched, mirroring the development in other markets such as equities, commodities, and FX but at an accelerated pace.
Options are a natural next step that will provide some much-needed risk management capabilities. As these developments make the market more investor-friendly, we expect to see banks, RIAs, and funds increase activity as they are better able to trade and manage risk.
We at Cboe Vest Technologies are excited about Bitcoin maturing and the new trading possibilities that are emerging. Just like we do in the equity options space, we will be following developments closely, providing analysis and tooling to support investors.