Futures contracts for dummies – a simple explanation

Trading futures contracts is another outgrowth of the stock market. Outgrowth sounds rather negative, I know, but the original idea of it is quite positive and offers great benefits. Nevertheless, many investors use the asset class for pure speculation. Cryptocurrency platforms caught up and thus it is also possible to trade futures with Bitcoin and co. What is the origin of this financial product and what advantages does it offer today?

Origin of futures contracts

The idea of futures contracts is the promise of one party to buy a certain good at a predefined price and the other party assures to deliver this good at the agreed time. It is therefore a contract that is bound to a fixed date in the future. Obviously, this is where the term futures contract comes from. The first futures transactions with commodities took place in Chicago in 1884: Midwest Grain Trade: History of Futures Exchanges

When closing such a deal, no goods change hands yet, but only a deposit is required, which is usually between 5% and 15% on the exchange. Trading Bitcoin futures requires a collateral of 50%. Consequently, one speaks of a purchase on margin.

John and the coffee vendor: A simple example

John lives in Chicago in June 1884. The first standardized forward transactions have become established. He needs 200 kg of coffee in October and agrees with the supplier that he will buy the coffee beans at the end of September at a price of 10 cents per kilogram. John makes a deposit of $2 and he will pay the remaining $18 when he receives the ordered product. John and his supplier have thus concluded a futures contract.

The future price is based on the current price, which is only 9 cents at the time of the agreement. Since the supplier already has a high load of orders at the end of September and John can’t store the coffee beans in the meantime anyway, he is willing to pay more in the future. Additionaly, he only has to make a down payment and remains liquid with the remaining $18.

In summary, the contract includes the following parameters:

  • Current date: June 1884
  • Delivery on: October 1884
  • Quantity: 200 kg
  • Current price per kilogram: 9 cents
  • Price to pay per kilogram on delivery: 10 cents
  • Deposit: 10% ($2)

How the price is formed for forward contracts

As shown in the example above, the price is determined on the supplier’s possible order situation in the future. It is therefore conceivable that the supplier has not yet concluded any contracts for the agreed date and that his order book is empty. To fill his order book, the vendor would offer John to supply him with coffee for 8 cents per kilogram, provided he placed an order with him right now. John would thus pay less for his order in the future than the coffee costs at the current time.

The supplier’s order book is in turn dependent on the availability of coffee in the future. If the expectation of sufficient coffee is low due to poor weather conditions, for example, the supplier will certainly be able to get rid of his coffee beans rather quickly and more expensively. The price of the forward transaction is thus formed from supply and demand of the commodity in the future.

Trading with futures contracts

John signed the contract and committed to buy the coffee by the end of September 1884. In August, however, he realizes that his customers no longer want to buy his coffee. His fear: «I’ll be stuck with the 200 kg of coffee beans!»

John talks to his colleague Robert. He also owns a store and coffee still brings him profitable sales. Robert is willing to buy the forward contract from him. But since the price of coffee has fallen slightly in the meantime, he does not offer John more than 9 cents per kilogram. Thus, John makes a loss on the remaining 1 cent. John and Robert have concluded a trade of a forward contract.

Of course, it is also possible that the price of coffee has increased in the meantime and Robert is willing to buy it for 11 cents instead of the 9 cents described above. John would then even make a profit on the contract. And this is exactly why futures trading came into existence on exchanges. To «buy» a contract with the hope that the price of the underlying asset will change positively for the investor.

Trading with futures contracts of cryptocurrencies

The futures of an asset are traded separately and they each have a delivery date. For example, you can buy or sell bitcoin futures with delivery dates 12/31 or 03/25.

It can be seen in the screenshot that futures contracts dated at the end of March are trading at a higher price than those with a delivery date in the preceding December. The reason for this is that more investors believe in an increasing Bitcoin price and are therefore willing to pay more for the futures contracts dated at the end of March. Overall, investors are optimistic.

Listing of the different markets for futures contracts trading on Binance: BTCUSD Quarterly 1231, BTCUSD Quarterly 0325, ETHUSD Quarterly 1231, ETHUSD Quarterly 0325 etc.
Screenshot created on Binance

In the example of John and the coffee vendor, this would mean that John would pay much more for coffee beans at the end of March than for December before. Because many of the supplier’s customers enter into forward contracts due to possible coffee shortages and the resulting potential inflation.

It is important to note that the futures marketplace, as on the screenshot in the following chapter, is a completely detached market. It is only tied to the Bitcoin spot market in that it forms its current price. The futures marketplace is then a projection of the possible BTC price in the future, which is based on the opinions and actions of investors. If the Bitcoin price falls, the futures price would also correct downwards, as investors no longer expect the same price in the future.

Price development of futures

Let’s take a look at a specific futures trading marketplace: Bitcoin Futures Quarterly with delivery date 12/31/2021.

Bitcoin futures marketplace with delivery date 12/31/2021. It shows that the futures are traded at a higher price than the current spot price of BTC.
Screenshot created on Binance

In the screenshot, the index price, i.e. the current BTC price, is framed in gold. It is thus evident that Bitcoin futures with a delivery date of 12/31/2021 are trading higher than Bitcoin itself (BTC futures: 62,221.9, BTC current: 60,402.0). The message is clear: investors are assuming that Bitcoin will have a higher value on 12/31 than it does today.

The further away the delivery date, the greater the gap between the futures contracts and spot price. After all, a lot can still happen between now and delivery. However, the closer the fulfillment date, the closer the futures price is to the current market price. On 12/30, an investor no longer assumes that the bitcoin price will rise another 10% by the next day (although this is not at all unusual for cryptocurrencies 😉). The following chart illustrates the price trend and the correlation of the two markets.

Example of how the correlation between futures contracts and spot price looks like. The Bitcoin futures delivery 12/31 trades for $62,000 on 10/15. At the same time, the bitcoin spot price is $60,000. Over the duration until 12/31, the two curves get closer and closer. Thus, on 11/23, the curves are only $1,000 apart, as opposed to $2,000 at the beginning. On the delivery date of 12/31, both prices are equal.
Chart created on infogram.com

The plot shows that on Oct. 15, the futures price is still trading $2,000 higher than the spot price. Over the following two and a half months, both prices converge so that they are equal on 12/31.

And what about John?

Let’s go back to the example with John, Robert and the coffee merchant: Robert is willing to buy the coffee beans from John one day before the delivery date. The current coffee price is only 7 cents. It is unlikely that Robert would offer John more than these 7 cents per kilogram. Especially since Robert would not have to worry about storage, nor would he benefit from liquidity due to a low down payment. Since John knows that probably no one else will offer Robert the coffee at a lower price, he would also insist on at least 7 cents.

There is just one remaining question

In the coffee vendor example, it is clear why John decides to pay more for the same quantity of coffee beans at a later date. After all, he cannot store the goods in the meantime or he would have to pay for the storage costs. But what kept me restless in the case of Bitcoin and other cryptocurrencies was the following question.

Why should I pay more for bitcoin through futures instead of just buying it directly?

Simply put, you buy bitcoin through futures at a higher price instead of buying it directly in the spot market at a lower price and consequently expecting a higher return.

Bitcoin do not need to be stored. So there are no additional costs if you own them. Well, not quite. If you buy Bitcoin via the spot market, then you have to pay the full market value of the purchased BTC. With futures contracts trading, you only have to deposit a percentage of the bitcoin traded. So the advantage is liquidity and not being liquid also costs something: opportunity cost. The money you save can be invested elsewhere in the meantime, or you can simply buy larger amounts. So let’s look at the examples in the next chapter.

Profit and loss when trading futures contracts

The examples all have the following starting point:

  • You have $12,000 and want to invest it in Bitcoin.
  • The current Bitcoin price is $60,000.
  • The current Bitcoin futures price is $62,000.

All sales in the examples always take place directly before delivery date or when the futures and spot prices are equal.

In the calculation of profit and loss, fees were neglected.

Example 1: Purchase in the Bitcoin spot market with price increase

  • You buy 0.2 BTC with the $12,000.
  • The price of BTC on the day of sale is $65,000.
  • You sell the 0.2 BTC and get $13,000.
  • Consequently, you make a profit of $1,000.

Example 2: Purchase Bitcoin futures with price increase

  • You buy bitcoin futures with the $12,000. Since you only have to deposit 50% as collateral, you can buy ~0.387 BTC futures with it. Or in other words: you can buy BTC futures for $24’000, because 50% of $24’000 = $12’000.
  • The price of BTC and accordingly the price of the futures is $65,000 on the day of sale.
  • Your ~0.387 BTC futures have an equivalent value of $25,161 (0.3870967742 * $65000 = $25,161) on the sell date.
  • Consequently, you make a profit of $1,161 ($25,161 – $24,000 = $1,161).

Example 3: Purchase in the Bitcoin spot market with price decrease

  • You buy 0.2 BTC with the $12,000.
  • The price of BTC on the day of sale is $55,000.
  • You sell the 0.2 BTC and get $11,000.
  • Consequently, you incur a loss of $1,000.

Example 4: Purchase Bitcoin futures with price decrease

  • You buy bitcoin futures with the $12,000 and get ~0.387 BTC futures.
  • The price of BTC and accordingly the price of futures is $55,000 on the day of sale.
  • Your ~0.387 BTC futures have an equivalent value of $21,290 (0.3870967742 * $55000 = $21,290) on the sell date.
  • Consequently, you incur a loss of $2,710 ($24,000 – $21,290).

The examples show that the greater liquidity in futures trading can be seen as a so-called «leverage», which has a major influence on profit and loss. Since the example shows a situation in a bull market with optimistic expectations, the loss is all the greater if these expectations do not happen.

In fact, the extra profit from example 2 is the reason why investors started to trade with leverage in futures trading.

How to profit from trading with futures contracts

Let’s take another look at the chart showing the correlation between BTC and BTC futures. On 10/15, the prices of the two assets show a divergence of $2,000 and we know that the two prices will meet with absolute certainty at the delivery date. Additionally, the two curves are based on the same assets:

  1. Bitcoin
  2. Bitcoin futures contracts

There must be possible to exploit this discrepancy. Doesn’t it? Yes there is! Contango: Your Chance for a Low-Risk Profit

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