Futures: Introduction and Origin

Background

You may have heard of futures before, but think it is too complex, difficult to get started, or only suitable for large institutions. They do sound a little intimidating. However, like options, futures are not just the exclusive tools of institutional or professional traders.

Futures have become increasingly popular among individual investors over the past 20 years, mainly for the following reasons.

First, futures allow individuals to access the market without investing large amounts of money in advance. Futures markets offer a wide range of investment opportunities, with contract sizes suitable for each type of trader.

Second, futures allow investors to go long or short, allowing investors to use these contracts strategically in their portfolios. Not only can they speculate on price movements, they can also manage risk and hedge their portfolios by locking in prices, and potentially profit from favorable market fluctuations.

So where do futures come from?

is rooted in agriculture

Futures originated in commodity markets, especially agricultural products markets. They ensure that buyers and sellers can lock in crop prices before harvest, hedging revenue and costs.

For example, if farmers are harvesting corn, they may sell futures contracts that agree to sell a certain amount of corn to the buyer at a specified price once harvested.

Even if corn prices fall, the contract allows farmers to cover costs and make financial planning in coming months. Similarly, it protects buyers by ensuring that even if market prices rise, buyers can buy corn at predetermined prices.

The concept of futures dates back to the 17th century, and the Chicago Board of Trade first introduced standardized futures in the United States in the 19th century.

Expansion and evolution

In the 1970s, futures markets began to expand rapidly under the supervision of the Commodity Futures Trading Commission (CFTC), established by an act of Congress in 1974. Currently, futures markets cover a wide range of assets, including but not limited to cryptocurrencies, stocks, foreign exchange, natural gas, crude oil, precious metals and many other commodities.

In the early 1980s, the CFTC approved cash-settled futures, allowing investors to settle contracts in cash instead of physically delivering commodities. These contracts quickly became popular because of their flexibility and ease of use, especially in financial products such as stock indexes.

The futures market has thus further expanded, attracting more institutional investors interested in speculating or hedging price movements of various assets.

Current market environment

Since the 1990s, smaller futures contracts have been introduced. This reduces capital requirements and exposure to full size contracts, making it easier for retail investors to invest in these contracts.

As more investors have access to a variety of assets, futures trading has become increasingly popular. Retail investors are increasingly using futures as an investment strategy to protect their investments, especially in times of market turmoil.

Advantages of Futures

Why are futures favored by retail investors?

Moderate size

Because Coinbase Derivatives offers contracts of various sizes, investors can gain exposure to underlying assets, whether it is Bitcoin, Ethereum (ETH) or Dogcoin, with less money than directly investing in assets.

Risk management

Investors can speculate on futures to make a profit when prices change in their favor; they can also use futures in their portfolios to reduce risk. If investors believe that an asset will depreciate in value, they can hedge against it by shorting futures on that asset, thereby benefiting from falling asset prices.

Tax incentives

Another benefit of futures trading is the tax treatment of realized gains and losses. Under Section 1256 of the Internal Revenue Code, which applies to futures, the IRS divides investors \'gains and losses into two parts regardless of the holding period:

60% of the gains or losses is taxed at the long-term capital gains rate, typically approximately 0-20%, depending on the investor\'s income.

40% of gains or losses is taxed at the short-term capital gains rate, which is usually the same as the normal income tax rate for investors.

This 60/40 ratio is good for investors. Even if investors have held contracts for less than a year (usually short-term investments), 60% of the gains can still enjoy a lower long-term tax rate.

Review

Key Terms

Exchange Exchange

A market where traders can buy and sell futures contracts. The exchange promotes transactions and ensures transparency, liquidity and standardization.

Risk exposure

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

Asset

Commodity or financial benchmark on which futures contracts are based. The assets or underlying assets can be: physical commodities such as oil or wheat; financial instruments such as foreign exchange; or the Standard & Poor\'s 500 Index or Nasdaq Index.

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.

Although futures have become increasingly popular in recent years, their rise has not been achieved overnight. Futures have a long history of use in commodity markets and have now developed to become more accessible to retail investors.