The Bottom Line

 All you need for smart financial decisions

Bitcoin, Bananas & Bermuda (shorts)

A How to Guide on Cryptocurrency Futures 

Bitcoin may be a new(ish) investment but its price movements are susceptible to the same "old" influencers, including a "short squeeze" - a jump in price due to sellers having to cover short future positions. 

Futures contracts allow you to bet on the price of bitcoin in the future, today. 

Why Futures are used and how they affect prices are more easily understood when applied to a familiar item like bananas. 

Written by Stacy Marcus                                                            Updated March 2021

Feel like you missed out on Bitcoin … again?  Think its "back to the moon"… again?

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A rapid jump in the price of a stock, commodity or currency - especially when there is no economic or financial news and the rest of the market is quiet, is often due to a “short squeeze”.

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What Is a Short Squeeze?

A short squeeze occurs when there is an excess of short selling - people who did not own the asset (stock, bitcoin) who have agreed to the sell the stock in the future because the stock have bet that its price would fall when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses. Their scramble to buy only adds to the upward pressure on the stock's price.

In the stock market, a short squeeze is a rapid increase in the price of a stock owing primarily to an excess of short selling of a stock rather than underlying fundamentals

so there will still be plenty of opportunity to take whatever side of the market you favor once you understand.

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During trading on a particular day, the price of Bitcoin jumped $1,000. 

The jump was due to a covering of SHORT positions – some to take profit, others to cover losses.

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What is a SHORT?

It’s when someone who doesn’t yet own something had made a promise to sell it at a certain price sometime in the future. 

For example, imagine Apple stock is trading at $300 today.  You believe that Apple stock will be $200 6 months from today.  You do NOT currently own any Apple stock. I believe Apple stock will be $500 6 months today. So you agree to sell me Apple stock 6 months from today at a price of $250.  Since you don't own the Apple stock on that day in the future (or sometime before) you will need to buy it - cover your short sale, so you can sell it to me.

A Short Squeeze happens when lots of people who don’t yet own what they have agreed to sell at a certain price have to go to the market and buy to fulfill their obligation.

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Let's take the case where BITCOIN is trading at $9,000.

BITCOIN SHORT

In bitcoin terms, sometime in the past people who believed bitcoin was going to drop in price below $9,000 by today, sold bitcoin “short” – they sold bitcoin they did not own for delivery on a future date, and now the have to buy it to cover their obligation.

WHY? BITCOIN and BANANAS

There are two sides to any transaction. One side expects an increase in price, the other expects a decrease. Let’s put it in terms of bananas (versus bitcoin).  Imagine its January 1, 2020 and you will need to buy a banana in the future - on December 2020.

The price of a banana today is 10.

1. You believe the price of a banana will go up by December 2020.

This means you would have to pay more in December then you would today for the banana but you don’t need the banana today so you don’t really want to buy it now. Your goal is not to pay more for the banana in December then you would have to pay today.

2. I believe the price of a banana will go down by December.

If I am right, I will be able to buy the banana in December for a cheaper price than you are willing to pay for it and make a profit. I don’t own the banana today, and I don’t want to buy the banana today since I can’t sell it to you until December so I am “short” and will need at some time before I have to deliver you the banana buy it in the market.

So, on January 1, 2020, you and I enter into an agreement where I promise to sell you bananas in December at a price of 10. 

Now it is December 2020, and I must fulfill my obligation to deliver bananas to you, but of course I don’t have these bananas so I must first buy them – at whatever the price is today (spot price).

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If the price is less than 10, I’m happy since I’m selling to you at 10.

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If the price is more than 10, for example 11, I lose since I already agreed to sell to you at 10.

BITCOIN SHORT COVER 

This Twitter post shows a large bitcoin player “a whale” covering short positions. Most futures contracts expire on the same day in the same month and so many people may have to cover the short position at the same time - especially if the price has not dropped since the last futures contract expiration date.  The covering of short positions can be mistaken for a natural uptrend in the price rather than a brief jump from short covering that is unlikely to result in a long-term trend. 

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BOTTOMLINE

If you believe Bitcoin and other cryptocurrencies in the long term will rise in price (to the moon) there’s still plenty of opportunity to buy.  If you’ve been telling friends it will go to zero here’s your explanation for the current pop.

Regardless of your view on Bitcoin or another other investment opportunity remember to:

1. Carefully weigh the risk and reward,

2. Consider your time horizon,

3. Know your take-profit and stop-loss,

4. Don’t invest funds you may need in the short-term,

5. Speculate only with funds you can afford to lose.

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