WHAT “A FUTURE BITCOIN PRICE” REALLY MEANS

WHAT “A FUTURE BITCOIN PRICE” REALLY MEANS

The Chicago Mercantile Exchange just announced that it will start trading bitcoin futures as early as December 18. This is certainly a big step towards recognition for the main cryptocurrency.
But it is important to clarify the big misconception – despite its name, a future bitcoin contract, or any future contract for that matter, tells you nothing about the what price bitcoin will reach in the future.  It is a useful financial instrument for speculation and hedging, but no more.


This point is best explained by an example.


Let’s say there is a really optimistic investor called Joe who believes that a year from now bitcoin will be worth well over $20,000. Confident of his predictive powers, Joe agrees to enter into a contract with you to buy one bitcoin from you in December 2018 for twenty thousand bucks.

You enter into this future contract with Joe, and immediately afterwards, you borrow from your bank the current price of bitcoin, $12,000, and then purchase the bitcoin which you intend to deliver to Joe a year from now.  After a year goes by, you give Joe the bitcoin you purchased, and Joe pays you the twenty thousand dollars that he promised to pay when he entered the contract.

If the price of bitcoin a year from now is above $20,000, Joe will be a winner.  If it is below that level, he will lose.  But you don’t care, since you will pocket the profit of $8,000 minus the cost of the bank loan.  As long as Joe does not go bankrupt, you can repeat this trade as much as you want, and make unlimited amount of money with no bitcoin price risk.

Now, let’s consider the alternative case.  Let’s say you meet a very pessimistic bitcoin investor named Jil, who is certain that in December 2018 bitcoin will trade well below thousand dollars.  He is as confident of his predictive powers as the optimist Joe.  Therefore, Jil is willing to enter into a future contract to sell you one bitcoin a year from now for $1K.

You enter into this future contract with Jil, and then the very next day you find a friend of yours who owns a bitcoin, and ask him to borrow it for one year.  Then you sell bitcoin for the current price of $12,000.  A year from now, you use one thousand dollars to buy the bitcoin from the pessimist Jil, and return that bitcoin back to your friend.  Your profit from this trade: $11,000 without any bitcoin price risk.
As you can see, both in the case of Joe the Optimist and Jil the Pessimist, you were able to make money irrespective of what actually happens to the price of bitcoin a year from now.  The only thing that matters is whether your counterparty – Joe and Jil – are willing to honor their contractual obligation.

If this sounds too good to be true, you are right.  Nobody who understands how the futures market works will enter into the type of contracts which I just described.  The only price for a bitcoin future contract that makes sense is the current price of bitcoin plus the interest rate for a period of one year.  So, if bitcoin is worth $12,000 today, the price of a bitcoin futures contract a year from now will be twelve thousand dollars plus the interest rate for one year.  If the interest rate is a generous 10%, then the future price of bitcoin will be set at $13,200.

At that price, you will enter in as many bitcoin futures contracts as you will.  But you will not be able to realize any arbitrage.
As for what price bitcoin will command a year from.  Well, that is a completely different story, and it has nothing with the price for bitcoin futures.

 



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