1. What are futures?
Futures are an agreement to buy or sell an asset on a specific future date at a specific price.
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.
The goal is not necessarily profit maximization. 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.
2. How do futures contracts work?
There are two positions you can take on a futures contract: 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 when the contract expires.
A good way to explain this is using the example of an airline who wants to hedge against the rising price of fuel by entering into a futures contract.
Say jet fuel trades at $2 per gallon. An airline expecting the price of oil to rise, buys a three-month futures contract for 1,000 gallons at current prices. The contract is, therefore, worth $2,000.
If in three months, when the contract expires, the price of one gallon of jet fuels is $3, the airline saved $1,000.
The supplier will happily enter into a futures contract in order to ensure a steady market for fuel, even when prices are high. And 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.
3. What are Bitcoin futures?
Futures are not just for physical assets; they can be traded on financial assets as well.
With Bitcoin futures, the 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.
In addition, it enables investors to speculate on the price of Bitcoin without actually having to own Bitcoin.
It has two major consequences.
First, while 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.
Second, in areas where trading Bitcoin is banned, Bitcoin futures allow investors to still speculate on the price of Bitcoin.