It is widely known that derivatives (such as futures and options) and leveraged trading can be very risky, as it is possible to lose all the money by losing in a "bet".
However, derivatives can also be used to hedge one's risks, shaping them in the way he wants.
Let's consider an example. Suppose you already have 100 BTC. So you get $100 USD of profit each time BTC/USD exchange rate goes up by $1.
That's great, but you want more, suppose you believe that exchange rate continues to rise, so you want to double your profits.
One way to do that is to buy 100 BTC more, but you need $8000 USD to do that. Not everybody has that much money sitting in bank account, ready to be transfered.
Another problem is what it does to risk. If you double your long position, you double both profit and loss. Exchange rate droping by $1 means $200 USD loss for you.
And maximum possible loss goes from $8000 USD to $16000 USD... Let's be honest, risk exists. For example, government might close or isolate MtGox, or perform 51% attack. (It currently costs $5M USD to buy 60 Th/s worth of ASIC miners from Avalon... It is a pocket money for government.) Perhaps exchange rate won't fall down to 0, 90% loss is never a good thing. ($14400 USD in this example...)
So let's go back to futures... What if I tell you that you can increase your possible profits without increasing maximum
loss? It is possible.
I'm more familiar with futures trading, so I will use them in this example. I'll try to cover options once I do more research. Disclaimer: I'm not in any way affiliated with services I mention, I have no idea whether they are secure, aside from the fact that they haven't yet run away with money. Use at your own risk. If they run away with your money, that's not my fault.
So here's what you can do:
- Move 30 BTC into icbit.se account.
- Buy 800 of BTC/USD contracts (each contract is $10 USD, so 800 contracts is $8000 USD worth of Bitcoins).
- Now your profit&loss is same as if you bought $8000 USD worth of Bitcoin on market.
- You can take profit/loss at any time by buying 800 contracts, or you can wait until settlement.
Your maximum possible loss is still $8000 USD because you haven't put any more US dollars into it. But your potential profit is same as if you put $8000 USD... Cool, isn't it?
Well, there's no such thing as a free lunch, so there are caveats and downsides, of course.
First thing is that in case with futures, you aren't buying at current MtGox price, you're buying at futures price, which is subject to supply and demand on its own. Currently BTC/USD-04.13 futures trade in 95...100 range, which is quite above $89 on mtgox. This happens because there is higher demand on ICBIT, and people aren't willing to arbitrage.
If you buy at $95 you will get profit only if price goes above $95. (In case with BTC/USD-04.13 settlement happens on 2013-04-14, so you take profit if average mtgox price is above $95 on that day. But you can sell any time before settlement.) If it is lower than $95 you have a loss. Also, don't forget about trading fees, they are 0.003 BTC per 1 contract for this specific contract.
This sounds like a bummer, but note that there are contracts which settle in June and September. They might offer more reasonable futures prices.
Another thing to note is daily clearing. Clearing price is calculated every day at 20:00 UTC, amount equivalent to profit&loss is added or subtracted to your Bitcoin balance, and execution price is reset to clearing price. Some people freak out when they see it, but that's just how it works. In the end, your overall profit & loss is same no matter how many clearings there were...
Except one thing: forced liquidation. If your loss isn't covered by your Bitcoin balance, exchange will try to liquidate you position, possibly at unfavorable price... And you might end up in debt to exchange.
But do not worry, they do not know where you live :) , so maximum loss on futures is limited by the amount you deposited. Say, if you deposited 30 BTC you cannot really lose more than 30 BTC. But futures price might go down and then bounce back, so this is still an additional risk. (Note that you can save your position by depositing more bitcoins, but that increases your maximum potential loss...)
If some traders will end up in debt, exchange will cap profit of other traders... That sucks, but likely missing profits won't be significant. Also, you're guaranteed to have at least some profit.
And, of course, there is a risk of outright fraud and theft... Having bitcoins on exchange's balance is not same thing as having them in your wallet. But still, your loss is limited. Now let's talk about taking short position... Of course, it is possible with futures trading: just sell contracts you don't have. They work in a same way, but there is an interesting opportunity:
when futures price is above spot price (say, on MtGox), you can arbitrage, i.e. earn money without taking a risk. (EDIT: Not completely without risk, you're exposed to daily price fluctuations on MtGox because ICBIT settles in Bitcoin and you need to move money to MtGox to close position completely.)
(I'm talking only about trading risk, you're still exposed to counter-party risks.)
For example, suppose you start with having $8000 USD on mtgox. You buy 100 BTC @80 and move 30 BTC to ICBIT account, then sell 1000 BTC/USD contracts @100. After settlement, you move bitcoins back to Mtgox and sell them... And you're
guaranteed very likely to earn certain profit in US dollars, no matter what Bitcoin price is.
Here's a detailed description of arbitrage from exchange operator: https://bitcointalk.org/index.php?topic=131622.0
Now, while we are here, I've been advocating secure derivative trading based on "blockchain escrow" (multi-sig, to be specific) which would not allow an exchange to run away with money. I've even been trying to build it myself for some time, but haven't got anywhere yet. I mention this just so you people understand that I'm not a shill for ICBIT.
Derivative trading might be fun, I recommend starting with some small amount. Say, 0.1 BTC is enough start on ICBIT. Consider putting more into it only when you're comfortable.
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