Risk Factors – Funds Involving Derivatives, Including Forex Futures

The following risk factors describe a sample of risks inherent to any private fund we may offer that involves derivatives, including forex futures. This list is not intended to be exhaustive, and it should be considered in conjunction with the broader document on general risk factors inherent to any private fund we may offer.

Additional Information

Risks inherent to options and futures involving Bitcoins are a superset of those inherent to options and futures denominated in fiat currencies. Prospective participants in Bitcoin-denominated options or futures activities should therefore ensure they are fully aware of all relevant risks inherent to fiat-denominated activities in these areas.

The SEC’s investor bulletin on forex trading provides additional background, as does The Options Clearing Corporation’s document on the Characteristics and Risks of Standardized Options and Supplements.

Liquidity and Standardization Risks

Particularly with respect to derivatives, the Bitcoin economy does not provide the level of liquidity or standardization that investors expect in the fiat world. This severely restricts the utility of derivatives as a reliable component of Bitcoin-denominated growth strategies. It is not unusual to find both futures on Bitcoin versus the dollar and individual company options radically over-priced relative to theoretical pricing models, and it is not unusual to find insufficient market depth in either to support anything other than relatively small positions. The absence of market makers and the structure of existing markets for trading derivatives also make it impossible to enter even the most basic of combination positions, such as vertical spreads, without the higher risk of “legging in” (if at all). Butterflies are just a distant dream. Nor is it typically possible to liquidate such a combination position reliably, and in the absence of a central clearinghouse acting as guarantor and facilitating orderly assignment, failing to liquidate prior to expiry introduces risks of its own.

The fund manager has written separately about this in The Puzzles of Bitcoin Options for Ordinary Investors.

Limited Availability of Genuine Forex Futures and Forex Margin Trading

Although the word ‘futures’ is used by many in the Bitcoin economy to refer to products that have little or nothing to do with the futures contracts familiar to the fiat world, potential fund participants should be aware that genuine forex futures are, as of this writing, available from only one exchange (ICBIT). Other platforms, such as BTC.sx, offer related products which function like margin trading coupled with a guaranteed stop loss order. Forex margin trading per se is available on more than one exchange but has developed most strongly on Bitfinex. The upshot is that the available space for leveraged forex operations, including forex futures, is extremely limited, and the impairment of one or more of the relevant exchanges could severely impact the operations of any fund relying on their services.

Unpredictable Contango and Backwardation in Futures Markets

The tasks of initiating and maintaining directional positions in the futures markets are complicated by unpredictable expansion and contraction in contango and backwardation. A simple long position in Bitcoin versus US dollar futures may, for example, lose value even while the value of Bitcoin rises against the dollar, should contango contract significantly (or should the market transition from contango to backwardation) during the same period. Likewise, a simple short position in futures may lose value even while the value of Bitcoin falls against the dollar, should contango expand significantly (or should the market transition from backwardation to contango) during the same period. In other words, one may be entirely correct in one’s assessment of the directional development of the spot market and yet still lose money due to changes in the difference between spot and futures pricing.

Liquidity and Futures Trading Collars

Trading in futures on Bitcoin versus fiat currencies, such as those offered by ICBIT, is typically constrained by a collar — such as plus or minus 10% relative to the price at the previous clearing — which may be narrower than the spot trading range. When trading is restricted by such a collar, it may become impossible to exit positions at all, let alone at appropriate prices, until the collar is reset at the next clearing.

Fund Manager’s Limited Experience and Competence in Forex Futures

Although the fund manager has many years of experience in using derivatives as an approved level 4 options trader — where ‘level 4’ means approved for all options strategies except for writing naked calls, in which he has no interest — he has limited experience in forex futures and related instruments. His personal investment activities as well as his management of the original BTC Growth fund have involved significant forex activity across three platforms, including ICBIT, Bitfinex, and BTC.sx, but a mere few months of experience in forex futures and related forex activity places his competence in the area significantly lower than in ordinary options. (He has also used the quasi-options available on “THE” exchange, but — like almost everybody whose experience with investing began before Bitcoin’s brief childhood — realizes that that particular exchange is best ignored.)

Forex Futures and Forex Arbitrage are Not the Same Thing

Many individuals and several fund providers in the Bitcoin economy claim to engage in forex arbitrage, for example by exploiting cross-exchange differences in available rates between Bitcoin and fiat currencies. However, in most cases this “arbitrage” is not arbitrage at all; by definition, the activity of arbitrage generates risk-free profit by buying and selling a given underlying asset simultaneously. Conducting one transaction at a time and shuffling the resulting currency positions between exchanges is not arbitrage.

Potential participants in Bitcoin-denominated forex futures activities should understand that most forex futures activities are not risk-free and most are not arbitrage, regardless of how popular it might have become to refer to any activity involving more than one exchange as “arbitrage”.

Diversification and the Risk of Derivatives

Activities involving derivatives, including forex derivatives, may involve especially high levels of risk. Potential participants in Bitcoin-denominated activities involving derivatives should be aware that activities involving forex derivatives in particular are not suitable for the allocation of any significant proportion of an individual’s available capital.

No warranty or representation, either expressed or implied, is given with respect to the accuracy, completeness, or suitability for purpose of any view or statement expressed on this site. This article was originally published by on and was last reviewed or updated by Dr Greg Mulhauser on .

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