Bitcoin futures explained! With the CME Bitcoin futures trading live, it's important to know about forward contracts, long positions, short positions, leverage, derivatives, & other aspects of financial instruments.
Be sure to subscribe to our channel here: https://www.youtube.com/c/CryptoCoinConsultants
And feel free to also watch it on YouTube here:
Script:
Forward contracts
To really understand how futures work, we need to take a look at how and why they started. Say you were a wheat farmer in the 1800s. Back then, the price of wheat was very volatile, and how much money you made was entirely at the mercy of things outside of your control; weather, harvest quality, etc. If I wanted to buy wheat from you, I’d never know what price I can expect to pay each year since the demand for your wheat might be higher than the total amount of wheat you have available. You also don’t know how much money you’d be making since your next harvest might be of poor quality. So how can we resolve this? You & I make an agreement: you sell me your wheat at a price that we agree on today, with the wheat being delivered to me at a future date; say, one year from now. This locks in a set amount of wheat for me at a price we can both agree upon, while at the same time guaranteeing you some cash flow to help with your next harvest. This agreement to buy now & deliver at a later date is called a “forward contract.” Futures are a form of forward contracts.
What are futures?
Let’s take the wheat example a step further. Say you wanna sell me wheat now because you speculate the price of wheat to go down in the future, and I agree to buy wheat from you because I think it’ll go up. Let’s set the current price at $500 for 5,000 bushels. We formalize the agreement in a contract, and it expires 3 months from now. One month from now, the price of wheat goes up to $600 per 5,000 bushels with 2 months remaining in the contract. You still think the price is gonna go down & drop below $500, whereas I think it’ll remain above 500. In this case, the contract remains valid. But let’s say you & I both expect the price to go up even further. If we both agree to it, I can sell you the 5,000 bushels of wheat for $600, which allows me to keep my profits & lets you hedge your losses to only $100. We agree to this, formalize it in a new contract, and make the exchange. While old contracts can’t actually be destroyed, the creation of this new contract--in essence--nullifies the conditions set in the first contract. This sort of gambling on a commodity’s price is the primary basis of a futures contract. It’s a way to speculate on price fluctuations of not just commodities, but other assets like gold or stocks. But futures are merely financial instruments, or monetary contracts between two parties like you & I. While there’s no intent to actually deliver the wheat in our example, the contracts are a way for us to gamble with one another on the future price of wheat. So futures markets are essentially a zero-sum game, since my profit means your loss & vice versa. In our wheat example, your position as the seller is called the short position, while I hold the long position as the buyer. Also, profits & losses are calculated on a daily basis, rather than monthly, like what we did earlier. So if we were to move our wheat contract example into an actual futures market--and the price has gone up on day 1 to $510 per 5,000 bushels--your account would be deducted $10, while mine would be credited $10. Prices move everyday and therefore, adjustments & positions are settled everyday as well.
Who benefits from a futures market?
There are two types of traders who can benefit from futures: hedgers & speculators. Hedging is a way for you to minimize your risk as much as possible by locking up a price now on future purchases or sales. Speculators, on the other hand, seek to take advantage of price movements by profiting from them. So from a short position (or as a seller) you can hedge by locking in a price now to protect yourself against price drops in the future. Those in a long position (or as buyers) seek to hedge by protecting themselves against price increases in the future. Speculators long by anticipating a price increase in the future, which means they hope to increase the value of their holdings.
How do I participate in a futures market?
Entering a futures contract will always require a “margin” (or an initial deposit made into your account that’ll be credited or debited) on a daily basis based on the market’s movements. This first deposit is called the “initial margin,” and when you decide to liquidate it, it’ll reflect either a profit or loss depending on how the market moved during your contract’s term. The minimum amount you’re required to deposit (also called the “minimum-level margin”) can be anywhere from 5-10% of the futures contract, but can also vary based on other factors like exchanges or market volatility. If the balance of your account keeps losing money, it’ll eventually hit the maintenance margin, or the minimum amount it’s allowed to reach before you’re required to top up your balance with more money. Let’s put all this together using the wheat example from earlier. Our futures contract states that I agree to buy 5,000 bushels of wheat from you for $500 with a 10% initial margin and a maintenance margin of $25. This means that you & I are both required to deposit a minimum of 10% of $500 (or $50) each into our respective accounts. The next day, the price of wheat drops by 2%, or to $490 per 5,000 bushels. I’d also incur a loss of 20% since I would’ve been able to buy the wheat cheaper by waiting a day, and you conversely gain 20%. This would reflect on our accounts by $10 being debited from my account & a credit of $10 to your account, making my account worth $40 and yours $60. If the price keeps dropping over the next couple days & my account gets reduced to the $25 maintenance margin, I’ll have to top up my account with more money in order for the contract to continue. This entire process of investing small amounts of initial cash to reflect the price volatility of bigger cash amounts is called “leverage,” and it can lead to huge profits but even bigger losses. They say, therefore, that futures trading is not for the faint of heart.
How does this apply to Bitcoin?
All the principles I’ve outlined in this video can be applied to the cryptocurrency market as well, the first of which is Bitcoin. And just like other assets traded on futures markets, there’s no real intent to actually send or transfer ownership of a Bitcoin from one person to another; so futures contracts themselves would have no effect on the underlying price of Bitcoin since people are simply just betting on which direction the price will move. On October 31st, 2017, the Chicago Mercantile Exchange (or CME for short)--which is the world’s largest futures marketplace--announced they’ll be adding Bitcoin futures to their marketplace starting on December 18th, 2017. But another futures exchange beat them to the punch--the Chicago Board Options Exchange--by opening their doors to Bitcoin futures trading just over a week earlier on December 10th, 2017. As a result, the price of Bitcoin on this particular day saw a massive surge to over $18,000 per coin. Regardless of how this’ll affect Bitcoin’s short-term price, the CME’s CEO put it perfectly when he said that opening up Bitcoin futures markets “will provide investors with transparency, price discovery and risk transfer capabilities.” In my mind, this brings us one step closer towards the end goal of all Bitcoin- & crypto-enthusiasts alike: adoption.
Disclaimer: This is not financial advice. I absolve myself of all responsibility (directly or indirectly) for any damage, loss caused, alleged to be caused by, or in connection with the use of or reliance on any content, goods or services mentioned in this article. As usual, DYOR.
