What are futures contracts?

What are futures contracts?

. 4 min read

A futures contract is a standardized exchange-traded forwards agreement to buy or sell a particular asset, called the underlying, at a predetermined price and specified time in the future.

A buyer of the futures contract takes on an obligation to purchase the underlying when it expires. The seller of the futures contract takes on an obligation to sell and deliver the underlying at expiration.

Futures have long been used for trade of commodities, securities and most recently Bitcoin and other cryptocurrencies. These are called the underlying assets, the physical or digital assets the contract represents.

Most of the time when you are talking about futures, you don't say "futures contract," you just say "futures." So when you meet with your buddy Pavel to talk about his degen trading, you'd ask "How are the futures today?"

Every futures has an expiration date, typically on a monthly or quarterly basis, but there are specialized contracts that expire every day or week. Futures usually on the third or last Friday of every month.

When an option expires depends on the needs of the trades who buy and sell them. A daily futures expiration would be necessary for companies who want to settle and deliver at end of business every day.

All futures contracts have a standardized unit of supply in the contract. 1 oil future represents 1,000 barrels of oil. 1 gold future represents 100 tory oz. of gold. 1 Bitcoin future on the CME represents 5 Bitcoin. Every future uses a different supply standard that is laid out in their contract specifications.

How do you hedge with futures?

When you are purchasing a futures contract, you are buying time. You may not be sure what the price is in a few weeks or months, but the futures contract allows you to lock in a specific price to buy the underlying at. This is what's known as hedging, it's when you protect your position or future output by locking in prices today.

Hedging is different from speculating, where traders buy and sell futures with the sole purpose of monetary gain.

Farmers and other commodities producers have used futures for centuries to hedge and lock in favorable prices. If a farmer thinks the growing season is going to be worse than average this year, he could sell his future crop at a higher price now with a future. Or if a Bitcoin miner thinks that the price of Bitcoin will drop, they can sell a future and protect their cash flows.

At expiry, the seller of the future must deliver the underlying asset. When the farmer's corn future expires, he takes his harvested crop and delivers it to a receiving bay. With Bitcoin and other crypto, the seller is required to either deliver the underlying asset or a cash equivalent.

What is the futures curve?

The futures curve is a graph plot of the different expirations and their prices. Here is what the futures curve looks like for Bitcoin at the time of writing this.

A future is a time based contract. You may not know price conditions in the future, but you can potentially guess based on the volatility of the futures contract and the time to delivery. As you get further away from the current date, the price will either increase or decrease depending on the current spot price, risk free rate of return, and other factors.

The shape of the curve is extremely important to traders and hedgers. Contango is when futures prices are higher than spot. Normal backwardation or backwardation is when futures prices are lower than spot. In the Bitcoin futures chart above, prices are currently in Contango.

The shape of a futures curve should be analogous to the interest rate curve for borrowing the underlying and holding it for the allotted time period.

During contango, prices are expected to be higher in the future and the cost to "carry" the asset is positive. Contango is typically the default state of futures curves as it shows there is a cost to hold an asset for such a long period and sentiment is positive for price.

If the futures curve inverts, its market participants saying that their expectations of future price growth are diminished or negative.

What is a cash and carry trade?

During periods of contango the simplest way to trade futures is the cash and carry trade. In a cash and carry trade, you hold the underlying while selling a future at a later date.

Using the chart above, if I'm mining BTC then I know that spot prices are 10,325 right now, but the December future is selling for 10,385 right now. That means there is a $100 or a 0.58% difference in price between the two assets. As this is a quarterly contract, if you were to repeat this trade over a year the returns would be approximately 2%.

In times of backwardation, the opposite happens. Traders are incentivized to sell spot and buy the future to collect the extra premium.

Conclusion

This is a basic introduction to futures contracts and how they function. If you have any questions about how futures contracts work or what some of the strategies to trade them are, join the Telegram group for further discussion.



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