When one buys Futures you enter an agreement to buy or sell an asset on a specific future date at a specific price.
Futures are essentially a risk management tool and the goal is not only focused on making a profit.
Once the futures contract has been entered, both parties have to buy and sell at the agreed upon price, irrespective of what the actual market price is at the contract execution date.
It’s a risk management tool, often used in financial markets to hedge against the risk of changing prices of assets that are bought and sold on a regular basis.
Futures are also used in portfolios to balance out price fluctuations on investments, where the underlying asset is particularly volatile.
These contracts are negotiated and traded on a futures exchange which acts as the intermediary.
How do futures contracts work?
A Futures contract will present two options: long or short.
If you take a long position, you agree to buy an asset in the future at a specific price when the contract expires. When you take a short position, you agree to sell an asset at a set price on a specified date.
For example: A trucking business can buy a Futures contract to hedge against an increase in fuel price. If petrol trades for R14 per liter, it can agree to buy 10 000 liters in three month’s time at that price. If in three months, when the contract expires, the price is at R15 per liter, the saving would be R10 000.
The supplier will happily enter into a futures contract in order to ensure a steady market for fuel, even when prices are high. The same contract will also protect them if the price of fuel unexpectedly drops.
In this case, both parties are protecting themselves against the volatility of fuel prices.There are also investors who speculate with futures contracts rather than using it as a protection mechanism.They will deliberately go long when the price of a commodity is low. As prices rise, the contract becomes more valuable, and the investor could decide to trade the contract with another investor before it expires, at a higher price.
What are Bitcoin Futures?
In the case of Bitcoin, the Futures contract will be based on the price of Bitcoin and speculators can place a “bet” on what they believe the price of Bitcoin will be in the future. This enable investors to speculate on the price of Bitcoin without actually owning a Bitcoin.
It has two major consequences.
Firstly, even though Bitcoin itself remains unregulated, Bitcoin Futures can be traded on regulated exchanges. This is good news for those who are concerned about the risks related to the industry’s lack of regulation.
Secondly, in areas like China, where trading Bitcoin is banned, Bitcoin futures allow investors to still speculate on the price of Bitcoin.
How do they work?
A Bitcoin future will work on exactly the same principles as Futures on traditional financial assets.
By anticipating whether the price of Bitcoin will go up or down, speculators will either go long or short on a Bitcoin futures contract.
For example, if an individual owns one Bitcoin priced at $18,000 (hypothetically) and foresees that the price will drop in the future, to protect themselves, he can sell a Bitcoin futures contract at the current price, which is $18,000.
Close to the settlement date the price of Bitcoin, along with the price of the Bitcoin Futures contract, would have dropped. The investor now decides to buy back the Bitcoin Futures.
If the contract trades for $16,000 close to the future settlement date, the investor has made $2,000 and therefore protected their investment by selling high and buying low. This is a basic example of how Bitcoin Futures work and the exact terms of each Future contract may be more complex, depending on the exchange, which will include minimum and maximum price limits.
What do Bitcoin futures mean for the Bitcoin price?
In the short-term, it pushes the price upwards as the overall interest in the cryptocurrency spikes.
The day after Bitcoin Futures were launched on the Chicago Board Options Exchange (CBOE), for the first time on a major regulated exchange, the price jumped by almost 10% to $16,936.