Don’t worry, I’ll explain what Bitcoin Futures, Physically Settled, and Commodity Futures mean in the article!
Imagine you’ve seen the oil prices at historically low levels and decided that there is some money to be made here. You’ve immediately logged into your brokerage account and bought the earliest settling oil futures contract. After all, you don’t know where the oil prices will end up in the long term, yet you want to benefit from this short term panic crash.
Then you haven’t checked it for a while and forgot to roll-out your contract close to expiration. The moment a truck came to your place to ask where to leave the oil barrels, it struck you that the type of futures contract you bought was not settling in cash but physical oil. Indeed a big oops moment!
This experience is not one that you would like to go through unless some intermediary holds the physically settled goods for you, or you have a storage space to put 300 barrels of oil in it.
The story here was precisely the situation traders were trying to avoid on April the 20th 2020, when we saw WTI oil prices plunge from $17.85 to -$37.63, more than a 300% drop, the most significant one day drop for US crude in history (Globalriskinsights, 2020). They were simply paying money to sell the oil that they were about the receive.
To understand the story here, let’s roll back to fundamentals a little and look at the terms mentioned here.
What are all these terms?
Futures are financial derivative contracts that obligate the parties to transact an asset at a predetermined future date and price (Investing, 2020). It means, if you think that the oil prices will be higher in the future, you may buy the right to purchase that expensive oil, close to today’s costs if you’re willing to pay now but receive the oil in the future. There are futures markets for all kinds of commodities, from oil to corn, gold to coffee, natural gas to gasoline, etc. called Commodity Futures, as I mentioned in the title.
The term physically settled is essential here, because if you buy this kind of commodity through futures when the contract expires, you need to physically get the good you’ve purchased, unless you sell your contract to someone else before the expiration date. The alternative to this is the contracts that expire in cash, so at the time of expiration, you receive the difference between your purchase amount and settlement amount. Then you don’t need to obtain the actual goods.
Bitcoin also has both of these future types, but I want to focus here on the physically settled contracts where you receive the actual bitcoins rather than the value difference in dollars.
Receiving physical Bitcoin is a lot more convenient than receiving hundreds of barrels of oil and commodities overall. A couple of reasons for this convenience are:
- It’s a lot easier to store a digital asset than a physical good.
- When the contract is about to expire, nobody will push the prices to negative values to avoid physical delivery.
- After receiving, it’s easier to sell your Bitcoins in a cryptocurrency exchange than to find a customer for your oil barrel.
In the pre-digital era, the assets were physical, and with Bitcoin, we can now own digital assets as well. Indeed, your money in the bank is also digital, but it’s not the same as fully owning an asset without depending on third parties for its custody.
Let’s look at the dark side
No story would be fair without also mentioning the disadvantages of Bitcoin futures as well.
The cryptocurrency markets are still not as regulated as commodities, so it’s more likely to come across a fraudulent Bitcoin futures exchange than a commodity exchange. Less regulation here may require a stricter case to build in a lawsuit in your favor.
Another consequence of the regulatory uncertainty is that the asset value is still at the phase of price discovery, and the announcement of every new regulation has a significant impact on its price.
Moreover, the total market cap of Bitcoin is still under 200 Billion dollars. Comparing its size with trillions of dollars worth commodity market, shows that there is not as much liquidity in crypto markets. Therefore there is a risk of high volatility.
The last concern on Bitcoin futures is that many exchanges allow up to 200x leverage when trading. In an already highly volatile market, this means an irrational amount of risk, and it’s more gambling than trading. In more regulated commodity futures, you’ll most likely be limited up to 10x leverage, which is still a dangerous game if you don’t know what you’re doing.
Looking at both pros and cons, I find Bitcoin futures preferable than other physically settled futures. However, based on your risk appetite, tech-savviness and knowledge of the different markets, your personal preference may differ. I hope you would find this piece insightful to make your own decision rationally.
Originally published at Medium on June 24, 2020.
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Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. Use this information at your own risk.
References
Making History: Coronavirus and Negative Oil Prices | Global Risk Insights
Since the beginning of the Coronavirus pandemic, there has been a loss of 1/3rd global demand — more than 30 million…globalriskinsights.comFutures
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future…www.investopedia.com
