Quarterly Investment Guide

For brave investors there's two ways to bet on bitcoin

Key Points
  • Cryptocurrency's price soared from less than $1,000 to nearly $20,000, then tumbled to a low of $6,647.33 over the weekend after a South Korean exchange said it was hacked.
  • There are now more than 100 bitcoin exchanges, though Google searches for bitcoin have declined by 75 percent.
  • Major financial institutions, including big banks and stock exchanges, are making investments that signal cryptocurrencies are here to stay, including the launch of bitcoin futures contracts.

Not many experts would recommend packing investment accounts like 401(k) retirement plans with bitcoin. The digital currency is just too volatile. But there's nothing wrong with setting a little aside — money you can afford to lose — for wild bets, like gambling a few bucks at a casino.

Mike Segar | Reuters

Bitcoin certainly offers an adrenaline rush. In 2017 the price of the cryptocurrency soared from less than $1,000 to nearly $20,000, then tumbled to a low of $6,647.33 over the weekend after a South Korean exchange said it was hacked. At press time on Monday it was trading at $6,768.00.

The investment signals remain mixed: Google search activity on bitcoin has declined by 75 percent as the price swooned from that $20,000 high, but major Wall Street firms are making investments that show they expect cryptocurrency to remain a part of the financial landscape.

There are two ways to bet on bitcoin: the "old-fashioned" way, through a specialized exchange; and, since late last year, buying or selling futures contracts.

Here's a look at what to consider in choosing one over the other.

Exchange-trading on the bitcoin spot market

New coins are awarded to "miners" for solving complex mathematical problems. Then the coins are bought and sold for dollars or other fiat currency in an account called a wallet, kept at a cryptocurrency exchange like Coinbase, Bitstamp or Kraken.

Trading on this spot market is a lot like trading a stock, with prices governed by supply and demand, and no role played by a central bank, like the Federal Reserve. Since bitcoin is not yet accepted by many merchants, its value depends on speculators' view on what others will pay in the future. To detractors, that encourages bubbles. Advocates see huge potential profits.

Most of the more than 100 bitcoin exchanges are only a few years old, and some have been victims of fraud, theft, hacks and growing pains, like halts during heavy trading.

A very cautious investor can buy on an exchange and then store the bitcoin code off the site or even on a piece of paper — that's what the Winklevoss twins and bitcoin early adopters have done, going so far as to cut up their code into pieces and store it in a vault using a system that only they understand to put the actual bitcoin code back together.

Bitcoin itself is full of risk, even if the trading and storage system is safe.

Unfortunately, bitcoin exchanges don't work as efficiently as the stock exchanges, said Param Vir Singh, professor of business technologies for the Tepper School of Business at Carnegie Mellon University.

"Bitcoin prices are volatile; the transaction speed is slow; the bitcoin trading platform is illiquid," he said, noting that, unlike stock exchanges, the bitcoin exchanges are generally not well regulated by the government.

The Nasdaq has expressed interest in offering cryptocurrency trading, while the NYSE has expressed interest in bitcoin ETF trading. The NYSE's parent company, ICE, is moving into bitcoin swaps and already offers a cryptocurrency data feed.

Trading in bitcoin futures contracts

Since late last year, bitcoin futures have been traded on two long-established futures markets, the Chicago Board Options Exchange (CBOE) and the CME Group exchange. These heavily regulated exchanges solve many of the problems found on the newer bitcoin exchanges, according to Singh.

"Because the future can be traded on regulated markets, it will attract investors, making the market liquid, stabilizing prices, and [it will] not suffer from low transaction speeds of bitcoin [exchanges]," he said, adding, "If prices stabilize, we may start seeing more companies accepting bitcoin as a mode of payment. This may further bring liquidity to the market."

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William Vranos, CEO at Green Key Partners, a New York City-based investment firm, said that the futures market is better equipped to handle spikes in volume, and that because futures traders don't own bitcoin itself, they need not worry their bitcoin will be hacked or stolen.

A futures contract commits its owner to buy or sell an underlying commodity, currency or market index at a set price on a given date weeks or months in the future. In most cases the trader never takes possession of the corn, crude oil or bitcoin covered by the contract. Instead, gains or losses are reflected in the changing price of the contracts themselves as the underlying asset rises or falls.

To close a position, the trader sells the contract or buys an offsetting contract to profit on the difference between the current market price and the one the original contract specifies. A bitcoin trader who keeps a contract to the end receives a cash payment for a win or must ante up for a loss.

"There are a plethora of issues in the cryptocurrency exchange space at the moment," said Kunal Desai," CEO of Bulls on CryptoStreet, a site for cryptocurrency education. "One of the main pros of trading bitcoin futures is being able to speculate on its price without having to deal with the shortcomings of the cryptocurrency exchange space."

Understanding the futures market and leverage

Most individual investors should stay away from the futures market because of its volatility and complexity.

On a bitcoin exchange, the investor trades at the coin's full price. For example, if bitcoin is trading at $8,000, an investor spends $8,000 on every coin priced at that amount. Most futures contracts involve leverage, allowing the trader to put up only a small fraction of the asset's price, but for bitcoin this "margin" is unusually high, at more than 40 percent. So the investor could control one $8,000 bitcoin for just over $3,200, plus a small fee for the transaction. If the price jumped 12.5 percent to $9,000, the gain would be 32 percent of the sum invested.

Of course, it works the other way too – leverage amplifies losses when things go wrong.

"The futures market can ravish even the most experienced traders, thus those new to bitcoin investing should look to invest on traditional bitcoin exchanges," said Andy LaPointe, founder of the education site BitcoinLearningCenters.com.

Some futures brokers can have bigger margin requirements, and some require high minimums to open an account, like $25,000 at TD Ameritrade. The futures exchange guarantees traders will get what they are owed but can demand more cash be put into the account if the bet is losing money. That's a serious risk when speculating on a volatile asset like bitcoin, LaPointe says.

Volatility creates opportunity in bitcoin futures, says CEO

Crypto exchange expenses vs. futures market expenses

A $10,000 purchase on a bitcoin exchange would typically require a commission of at least $100, according to Michael Mollet, director of product development at the CBOE, and potentially even more. After the purchase, there would be no cost for holding the bitcoin as long as the investor wanted.

A long-term investor using futures would have to buy a series of contracts to keep the position, but the futures exchange's customer fees tend to be small — as little as 50 cents for one futures contract — and the investor could stay in the market a long time before the costs exceeded those on a spot exchange, Mollet said. Brokerages like TD Ameritrade advertise commission-free futures trading, but would charge interest for margin loans, with the rate based on the size of the loan.

"The longer your time horizon the more likely it is that buying the physical coin and holding is going to look a bit more appealing" than using futures, the CBOE executive said, but he stressed that he meant a very long time before the cost of holding futures would overtake spot market bitcoin purchase commissions.

Shorting bitcoin

Some bitcoin exchanges allow account holders to short — bet that bitcoin will fall in value — but the ordinary investor cannot do this as easily with bitcoin as with stocks or exchange-traded funds. Shorting is easy on the futures markets, however, as the trader simply buys a contract to sell a block of bitcoin at today's price sometime in the future. If it works out the price will fall and the bet will pay the difference.

"In all, speculating through futures has been a nice addition for traders," Vranos said. "Going short is much harder to do in spot markets."

Futures markets are complex

Bitcoin exchanges are pretty easy to deal with if you have traded stocks, but futures exchanges are alien territory for many ordinary investors and require a much deeper understanding of the issues that determine risks and returns, things like time to expiration, volatility and the day's news. Futures traders need to stay on top of the situation all the time and be ready to buy or sell on short notice.

Another negative for futures is that traders who do not own actual bitcoin do not get the free coin issued when bitcoin "forks", says Nick Spanos, CEO of Bitcoin Center in New York City

A fork is sort of like a stock split and happens when a complex set of conditions are met. On August 1, 2017, for example, bitcoin speculators received one unit of bitcoin cash for every bitcoin already owned. The fork occurred after a number of big players called "developers" agreed to modify the algorithm to speed transactions as trading volume grew. Today, bitcoin cash trades at around $1,100, compared to under $7,000 for bitcoin itself.

The bottom line is that futures markets are generally more suitable for sophisticated investors who like risk and are likely to buy and sell frequently. Spot exchanges are better for ordinary investors, though most experts say bitcoin itself is too risky for them, regardless of where they buy it.

"Investors who do not want volatile investments should stay far away from anything to do with bitcoin in general," said Desai of Bulls on CryptoStreet.

Correction: This story has been updated to reflect that the price of bitcoin plunged to a low of $6,647.33 over the weekend after a South Korean exchange said it was hacked.