A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price at a particular date in the future. The Chicago Mercantile Exchange (CME) introduced their Bitcoin futures contracts in December 2017 and uptake has been steady, with almost 7,000 contracts traded per day on average in 2019.
This guide will outline the importance of bitcoin futures contracts and how the price action of these contracts can be used to trade other derivatives, such as Interdax’s BTC-PERP perpetual swap.
What are the Benefits of Futures Contracts?
The main benefits of futures contracts is that they enhance liquidity, the process of price discovery for an asset and broader acceptance amongst institutional investors. Individuals and businesses may use futures contracts to either hedge themselves against bitcoin’s volatility or to speculate to try and make a profit from the gyrations in the price.
Miners and Businesses Can Hedge Their Bitcoin Holdings
Suppose a bitcoin miner wants to protect themselves from price fluctuations, they can sell bitcoin futures to lock in a price at a certain date. For instance, if a miner bought bitcoin futures contracts on the CME equivalent to 500 bitcoins at a price of $9,000. They would then be protected from price volatility and can sell the contracts for $9,000 at expiry, say in three months time.
If the miner generates a revenue of 500 bitcoins during those three months and the price ends up at $8,500, they would gain from being a futures position. The miner would lose $500 for each mined bitcoin they sold, but they would also gain $500 from each bitcoin futures contract that they hold. Therefore, the miner has effectively sold their bitcoins for $9,000 each.
Traders Can Gain Exposure to BTC's Price Fluctuations
Traders can also use futures contract if they think the price of bitcoin will rise or fall over a period of time. For instance, if a trader thinks bitcoin will rise in the next three months, they could buy bitcoin futures contracts to gain exposure to bitcoin’s price fluctuations.
If in three months the price behaves as expected and rises, the trader will be in profit once the futures contract position is closed. Futures contracts are also useful to traders since they do not require purchase or storage of the underlying asset.
How to Trade Gaps in the CME's Bitcoin Futures
Since bitcoin is traded in spot markets 24/7, gaps (or windows) do not characterise bitcoin’s price action - where a gap is basically an unfilled space or interval. However, futures contracts are not traded 24/7 and give rise to gaps which provide potential price targets as well as indicating important support and resistance levels.
Gaps are seen as a trend continuation pattern, where an upward gap would suggest that the asset will continue to climb. On the other hand, a downward gap means that further downside is expected.
The price action of an asset usually fills any gaps and can be utilised by traders as part of their strategy.
For example, the chart below shows that over the weekend, the price of the CME's futures contracts jumped higher and opened an upward gap between $6,430 and $6,870 in May 2019. Once the markets opened on Monday, we could have set limit orders to buy near $6430 or use limit orders to sell once the price breaks below $6870.
Alternatively, you could have shorted from the highs after the market re-opened for the new trading week and target $6430. As shown below, the price filled the gap and the zone acted as a support zone, with the price continuing higher.
Another example is shown below, where the price gapped up from $8,230 to $8,550 during late May 2019. The gap was filled but this time the price moved below the gap, breaking the support zone. The ideal trade would have been to enter a short position near $8550 and exit around $8230.
The price continued lower after filling the gap but reversed after hitting support around $7500. Once you exited your short, the best thing would have been to wait for another gap to emerge in the futures price action and then trade off that.
Gaps are not always filled quickly (and are not always guaranteed to be filled), as shown by the example below with the gap between $8,515 and $8,985 that occurred during June 2019. The market did eventually fill the gap, but only after three months.
Until the gap from mid-June was filled, there were plenty of other opportunities to trade the gaps in the CME's futures market. For instance, we see that the gaps in July and August were filled pretty quickly, while September didn't provide any meaningful opportunities.
Once the market for the CME's bitcoin futures opens each Monday, we can see if there is a gap (there almost always is) and incorporate it as part of your trading strategy. If an upward gap forms, then it could serve as support and be a good zone to enter a long position.
However, if the gap is broken then the uptrend is invalidated. Similarly, downward gaps are found in downtrends and serve as good potential zones to go short. Therefore, we can think of gaps as zones of support and resistance.
You could base a strategy purely off the gaps found in the CME market (by going short or long in anticipation that the gap will be filled) or to provide another perspective when using your own strategies. For instance, it might make sense for your trading system to go short at the start of the week, but there might be a downward gap that might get filled by the price appreciating. Therefore, traders might want to consider the futures data for confirmation of their own strategies.