Cryptocurrency Derivatives Series: Hedging Dynamics For Bitcoin in 2020

Let’s just quickly glance at the underlying security price trend before we deep dive in to the hedging aspects of bitcoin.

BTCUSD (at Coinbase) is currently trading at around $7,360 levels (while articulating).

The year-2018 has been bearish rout for bitcoin price, during that phase, BTC price showed steep slumps and year-2019 has been mixed bag of sentiments, we could see no traces of slowing in its dominance as 2019. 

At the beginning of the year, BTCUSD price surged from the lows of $3,337 to the  year-highs of $13,868 levels (i.e. mammoth returns of 315 in percentage terms that too within a span of 6 months or so, refer above chart).

Although Year-2019 has been instrumental for bitcoin exchanges, crypto-traders and investors, it has been little turbulent. However, such robust uptrend has generated various price gaps in the CME Bitcoin futures contracts. The underlying price has also retraced 61.8% Fibonacci levels that has wiped off most of the gains in the year-2019.

Hence, hedging bitcoin has been crucial contemplating fundamental developments, it needs strategically establishing derivatives trades so that a gain or loss in the underlying exposure is offset by the changes to the value of the other position.

Usually, if one is prone to the risk factor associated with the open positions, then that should certainly be mitigated the risk either by reducing the position or by squaring it off or add some derivatives contracts to it. 

However, hedging using derivatives is observed as a useful strategy for traders who want to maintain their original bitcoin holdings in the digital wallets offered by various exchanges.

At the moment, we have predominantly three derivatives methods through which the price turbulence of bitcoin can be arrested, namely:

1) CME’s & Bakkt’s Cash-Settled BTC Futures Contracts

2) Bakkt’s Physically-Settled BTC Futures Contracts

3) Bakkt’s Options Contracts

CME’s & Bakkt’s Cash-Settled BTC Futures Contracts: These Bitcoin derivatives are available on both Chicago Mercantile Exchange (CME) and ICE’s Bakkt that are traded and cash-settled contracts to enable clients to buy and sell Bitcoin at a predetermined price and predetermined date in the future. This arrangement facilitates investors to mitigate price risks in the specified future and settles in cash on the expiration. The price discounts that traders pay for Bitcoin at CME’s futures indicates the bearish sentiments despite mild recovery above $7k mark from the recent while ago. Hence, it also enables them to speculate with its price. 

Bakkt’s Physically-Settled BTC Futures Contracts: We had CME BTC Futures so far, this facility is now available only on ICE-backed Bakkt who introduced this in last September. The listing of futures with physical delivery on a regulated exchange should serve to enhance the bitcoin market structure by allowing investors, particularly miners, to better hedge existing bitcoin exposures. This is because existing cash-settled futures may only allow for imperfect hedging as hedgers are susceptible to price risk associated with converting bitcoin to cash at maturity. And there is an issue of potential manipulation with cash-settled contracts as settlement is based on a collection of spot prices from a number of exchanges with variable liquidity, which traders may be able to manipulate around the time of the futures contracts expiry.  These are European Style, Strike Prices are allowed in $250 increments, Contract Size is one bitcoin.

Strike Price Intervals: Strike prices will be listed in $500 strike intervals. The Exchange will always list a minimum of 10 strike prices above and below the at-the-money strike for any given Contract Period. 

Bakkt’s Options Contracts: These are the first CFTC regulated option on futures contract for bitcoin, these contracts are based on the benchmark Bakkt Bitcoin (USD) Monthly Futures contract and settles into the underlying futures contract two days prior to expiry on ICE Futures U.S. Price discovery occurs completely within a federally regulated market and has no exposure to unregulated bitcoin spot markets. 

In addition to these arrangements, we’ve got some OTC players who, like, BitMEX, OKEx and Binance who also offer such derivatives contracts which are unregulated but little risky.