The large differences between the spot price of bitcoin and the cost of buying the cryptocurrency on the futures market create unique opportunities for traders. There are several factors that could drive this development, but it could be bullish for bitcoin’s price expectations regardless of the catalyst.
Odd developments may indicate a shortage of supply, or an increased demand for derivatives
As bitcoin matures and the ecosystem around it expands, the original cryptocurrency behaves like a commodity. With a robust futures market continuing to develop, bitcoin derivative contracts are also gaining in popularity and have a significant impact on the price structure.
This has led to a unique development that has taken place in recent months. Bitcoin futures contracts that are months away from settlement are trading at a significant premium to spot prices, also known as contango. This is a serious arbitrage opportunity that can temporarily lead to relatively high returns with minimal risk.
The contango explained
In more traditional financial markets, such as those for commodity futures, the structure of the futures price may differ significantly from the spot price of the commodity in question. One of the most common examples of constango is the price of oil. Suppose the spot price of oil is $50 per barrel and the contract to be performed in three months is $55 per barrel.
This $5 delta (the difference between the futures price and the spot price) gives traders the opportunity to make the most of it by closing a short-term futures contract at $55 per barrel and buying oil on the spot market at $50 per barrel. Futures that are higher than spot prices can be attributed to several factors, but this price scenario is called a constango.
For example, some market analysts believe that future demand will exceed current demand, causing traders to raise prices in the future relative to current prices. In other cases, analysts believe that supply will decline in the future, creating a shortage that could also lead to higher spending in the future relative to the present.
Other factors that affect counterparties’ transactions and reduce their profitability in traditional markets include storage costs. In the example of oil, the sale of futures contracts may require the seller to physically deliver the oil to the buyer upon settlement of the contract. In the case of the contango contract, the trader must take physical possession of the oil purchased today in the spot market for delivery of a short-term contract that expires in a few months.
This means that the trader must store the oil during this period to absorb the price difference, resulting in a cost that absorbs the $5 difference between the spot and futures price. However, unlike oil, other energy commodities, metals or agricultural products, bitcoin has no storage costs, whether it is 1 or 10,000 bitcoins.
A Risk-free crypto-currency trading
Bitcoin futures sales account for a significant portion of the daily volume of cryptocurrencies. According to Skew, futures volume has exceeded $50 billion almost every day for the past four weeks, reaching $50 billion on the 23rd. February: $184 billion.
On the counterparty side, futures prices are significantly higher than spot prices, in some cases 15-20%. This provides a virtually risk-free trading opportunity for traders who have access to futures contracts and spot prices.
Let’s say a trader can buy bitcoins in the spot market and sell them in the futures market for a contract that expires in three or six months. In this case, they can simply lock in this interest rate differential when the transaction occurs at the time of contract settlement (at the maturity and settlement date of the cryptocurrency or fiat contract).
While it is difficult to define a trade as completely risk-free, when executed multiple times, it can generate significant returns without necessarily exposing an investment portfolio to bitcoin’s volatility. By buying in one market and selling in another, a trader is effectively hedging and can make up the difference.
Causes of contango
The contango has already priced bitcoin for a significant period of time and may continue to do so, but for how long remains the main question for traders. There are many reasons for this price difference, but it is difficult to identify an exact trigger since cryptocurrencies are decentralized and data is lacking.
Some market players and analysts have pointed to recent stockpiling by companies, including demand from Tesla, Microstrategy and Grayscale Bitcoin Trust, as one of the factors behind the scarcity that has driven up prices. If this is added to the fact that miners are mining bitcoin in the hope of a further rise in price due to the fall in mining revenues from halving production, this could also lead to a significant shortage of supply.
When there is a shortage in the cash market, making it difficult to buy bitcoins, some investors buy at a premium in the futures market, causing the futures price to rise. Moreover, as futures trading becomes more popular, the security of bitcoin’s own futures contracts may affect prices. Collateral, which is basically an asset against which money or cryptocurrencies are borrowed, serves as a financial guarantee for the trader when opening a position.
By securing collateral for crypto assets and using that collateral to buy leveraged futures, these two factors can work together in tandem to lead to higher prices. However, the onset of contango itself may also be a factor. Suppose traders see this divergence and rush to take advantage of the arbitrage opportunity. In that case, they can buy bitcoins in large quantities in the spot market and sell the same quantity in the futures market. This scenario could lead to a self-reinforcing deficit, which would cause prices to rise again.
However, arbitrage opportunities do not generally extend over a long period of time. As more and more market participants enter this sector, the delta (difference) between cash and forward prices is likely to narrow significantly, ending the high returns that currently characterize this sector.
Nevertheless, this price scenario could persist in the near future, given the possibility of a severe shortage of coins, hesitancy among miners, hoarding of coins by companies and increased participation in the bitcoin derivatives market. With the finite parameters of bitcoin supply and increasing demand, the situation is ripe for a shortage that could drive up prices indefinitely.
Based on the current market forces explained here, do you think the price of bitcoin will really continue to rise indefinitely? Let us know your comments in the section below.
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