Fundamentals of futures: Understand basic concepts

What are futures?

A futures contract is an agreement between buyers and sellers to exchange relevant assets or indices at a predetermined price at a future date or when the contract expires.

In short, this is a contract that ensures that both parties can express an opinion on the future price of the asset.

For example, Bitcoin is traded 24 hours a day, 7 days a week, which means that its price is constantly changing. Investors can use futures contracts to hedge the price of Bitcoin.

Long and Short

The futures market provides investors with two ways to participate in investing in various commodity and stock indices: \"Long\" or \"Short\".

What is doing long?

Being long is like buying a stock or ETF. If investors expect the price of an asset to rise, they can buy a futures contract for that asset, hoping that the price will rise between the initial purchase and the expiration date. They can sell at any time before expiration, and if the price goes up, they can make a profit.

What is short?

On the other hand, investors can short and sell futures contracts on the asset if they expect the price of an asset to fall. Whether they are long or short, investors can trade and close their positions at any time before the contract expires, or hold until maturity, and collect or pay the difference between the transaction price and the final settlement price in cash.

What are leverage and margin?

Long or short require investment. In the futures market, the margin for investment is included in the futures contract.

Margin for futures trading is the deposit required to open a position on a contract. The amount of the deposit will depend on the cost of the underlying asset and the requirements of the broker. Margin may also increase when you hold long or short positions.

However, this deposit is leveraged. Leverage allows you to control larger market positions with less upfront capital deposits, giving you a greater exposure to potential gains or losses.

Let\'s take a look at examples of using margin and leverage to go long and short.

Example: Go long

An investor wants to go long 10nm Bitcoin futures. The nominal value of each contract is US$1,000. This means that even if the price of Bitcoin is US$100,000, investors in each nano-Bitcoin futures contract (1/100 of Bitcoin) can control US$1,000 worth of Bitcoin.

When opening a position, investors need to deposit 25% of the nominal value as margin. The total nominal value of the 10 contracts is US$10,000 (10 contracts x US$1,000 each). When a 25% margin is required, investors must invest US$2,500 (25% of US$10,000) to control their positions.

If the nominal value of each contract rises to US$1,500 before the contract expires, investors can profit from price increases when closing their positions. The new total value of the 10 contracts is US$15,000 and the profit is US$5,000 (US$15,000-US$10,000).

However, leverage can also increase risk. If contract prices fall, investors may lose their initial margin and may be required to cover any additional losses. Still, most futures brokers may close their positions before losses exceed the initial margin, and they will make this clear in their specific risk policies.

Example: Shorting

Now, suppose investors think the price of Bitcoin will fall and decide to short these 10 nano-Bitcoin contracts.

Similarly, the nominal value of 10 contracts is US$10,000 (US$1,000 x 10), and the initial margin required to control the position is US$3,000 (30% of US$10,000).

If the nominal value of each contract is reduced to US$500, the total contract value will be reduced to US$5,000 (US$500 x 10). In order to close the position, investors will repurchase the contract at a lower price, locking in a profit of US$5,000 (US$10,000-US$5,000).

Review

Key Terms

Be Long

If investors expect asset prices to rise, they will take corresponding positions, just like buying a stock or ETF.

Short

If investors expect asset prices to fall, they will take corresponding positions. They will sell a contract and hope to buy it back later at a lower price.

Lever

Margin futures allow you to control large positions with relatively little capital or initial margin. Leverage provides traders with significant exposure to the underlying asset without having to pay the full value of the contract in advance.

Margin

Deposit required to open a position in a futures contract. Typically, margin is a small portion of the nominal value of the contract.

Risk exposure

The extent to which investors are affected by changes in the value of the underlying asset under the contract. Essentially, risk exposure represents the amount of risk a trader may face due to market fluctuations, i.e. potential profits or losses.

The main characteristics of futures are margin and leverage, as well as the ability to hold long and short positions, providing people with convenient investment opportunities.