The third and final installment of the series on trading Bitcoin options was going to be dedicated to futures and options products available an online exchange called Deribit. It still is, but given the recent price volatility in Bitcoin and other cryptocurrencies, I want to start with a bit of editorial about financial regulations and the significant risks of unregulated (or sparsely regulated) marketplaces.

In general, I would describe my feelings about market regulation as capitalist - and somewhat libertarian. A baseline amount of regulation is necessary to make all market participants confident that the playing field is level and fair. If you’re trading and investing in the market for listed equity securities and associated derivatives, there’s no guarantee that you’ll make a profit, but thanks to the Securities and Exchange Commission (SEC) and Federal Securities laws, you can be sure that you’re not participating in a scam.

There are fair and open marketplaces in which you can buy or sell your choice of instruments with confidence that your brokerage representatives and the exchanges themselves are completely legitimate, sufficiently capitalized, and have your best interests at heart.

In the extremely unlikely event that a brokerage firm isn't solvent enough to meet demands for customer withdrawls, the Securities Investor Protector Corporation (SIPC) insures deposits.

The Commodities Futures Trading Commission (CFTC) plays much the same role in the trading of physical commodities and exchange-traded derivatives on a number of commodity and financial assets.

Central clearing means that you don’t have to worry about the solvency of your counter-party in any given trade or of the custodian of your assets while you hold a position. The clearing house is the literal counter-party to every buy and sell, collecting margin deposits from every market participant to ensure that the obligations of each transaction are met.

Of course, you are free to make “bad” trades – that the libertarian part, of course. Any of your trades might end up being unprofitable based on poor information, poor timing, a poor thesis or simply bad luck, but you’re not going to be ripped off by a scammer with nefarious intent.

There’s also a question of the robustness of the marketplaces themselves. With the vast majority of trading occurring in an electronic format, the hardware, software and administration strategy of the individual exchanges are crucial to smoothly functioning markets. The exchanges have two important tasks – the aggregation and dissemination of price data and the matching of transactions.

Those fairly simple functions get considerably more difficult when volumes start to rise. The established stock and derivatives exchanges spend enormous sums on building and maintaining networks that can handle the traffic of busy periods in the markets. The same goes for those providing execution and brokerage services. I recall a televised interview with Interactive Brokers (IBKR Quick QuoteIBKR - Free Report) founder Thomas Peterffy in which he was asked about service outages at discount broker Robinhood during periods of high market volatility.

Peterffy was clearly a bit amused by the fact that Robinhood thought they could keep up with the demands of providing accurate data and reasonable response times while skimping on technology costs to keep expenses and prices down. As a 50+ year veteran of the markets and having built one of the most expensive platforms in the world for trading financial assets, he knows how expensive it is to maintain systems that operate reliably when you need them most.

It almost goes without saying that the weak links in any brokerage or exchange system are going to become apparent at precisely the time that traders can least afford to lose functionality – when prices are moving quickly and a large number of trades is occurring. Any cost savings you enjoyed evaporate almost instantaneously when you’re locked out of the markets at the exact moment you need to make a trade.

One of the first notable events in the history of Bitcoin trading was the collapse of the “MtGox” exchange early in 2014. Roughly 850,000 bitcoins disappeared (presumably stolen) and almost $500 million was lost. (The exact figure is unknown, but a bitcoin was worth around $600 at the time the incident was reported.)

Though MtGox was the largest cryptocurrency exchange in the world at the time, it wasn’t started for that purpose. M.T.G.O.X originally stood for “Magic: The Gathering Online Exchange” – a trading venue for the cards of a Dungeons and Dragons-type fantasy game.

The collapse temporarily threw a wet blanket on enthusiasm for cryptocurrency, partly because of the potential for unexpected fraud and losses, and partly because many people hadn’t realized they were transacting on a platform invented for fantasy game tokens.  

Obviously, that negative sentiment was short-lived…

Bitcoin Options

In 2016, two Bitcoin entrepreneurs founded Deribit, a cryptocurrency derivatives exchange that initially limited to Bitcoin, but now also includes trading in Ether futures and options. The product offerings are fairly straightforward. The platform offers traditional futures contracts and European-settled options as well as a “perpetual” contract - which is similar to a futures contract except that it has no expiration date. The accounts of buyers and sellers are settled daily with the appropriate credit/debit based on the day’s move in the underlying currency.

In January, strike prices were listed up to $200,000 for Bitcoin.

On the Deribit website, the company lays out it’s detailed structure for account and risk management. It certainly looks as though they’ve done a thorough job of planning for maximum risk mitigation, including keeping a tiny fraction of margin liquidation orders in an “insurance fund” intended to compensate customers in the event that an account bankruptcy creates a big debit.

I tried but failed to get any hard details about the ownership structure and capitalization of the Netherlands-based company. Unsubstantiable reports put the recent valuation assigned by private investors at between $300 and $700 million.

Like other options exchanges, Deribit even publishes a volatility index based on the observed prices of options trading on the platform. Coinbase Global (COIN Quick QuoteCOIN - Free Report) – the new largest Bitcoin exchange – regularly refers to Deribit market data in its own releases.

How does it all work? I don’t know. It’s not available in the US.

Here’s a list of the countries in which the service is unavailable, according to their website (apparently the restrictions include citizens or residents of these countries, even if they are domiciled elsewhere):

·         Cuba;

·         Guam;

·         Iran;

·         Iraq;

·         Japan;

·         Democratic People's Republic of Korea;

·         Panama;

·         Puerto Rico;

·         Samoa;

·         Sudan;

·         Syrian Arab Republic;

·         United States;

·         Virgin Islands (U.S.).

It’s a somewhat bizarre list. It overlaps mostly – but not perfectly – with the countries' relative acceptance of sanctioned gambling activity. In the US, that’s the way regulators seem to have considered cryptocurrency, not as an asset or a means of exchange, but as a bet.

So Where Should You Trade?

I started this series by describing the futures and options available at the Chicago Mercantile Exchange Group (CME Quick QuoteCME - Free Report) for a reason. The “Merc” remains the gold standard for deep liquidity, sophisticated risk-management and margin practices and electronic trading systems that perform flawlessly even in periods of high volatility and volumes.   

If you want to trade crypto derivatives, my recommendation is that you establish a futures account and explore the Merc’s products. Trading in unregulated markets might seem like the easiest solution, but it also might be the easiest way to suffer large and unexpected losses. Choose your venue and brokerage representation carefully.

-Dave

David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.