The workings of futures
Tags: Finance, Trading, Bitcoin, Investing, Cryptocurrency

So, the title may seem a bit harsh and you might think, well why would anybody in his right mind call professionals in the financial markets gamblers, they make a ton of money?

Well, the ones you hear about make fortunes, those that lose them tend to end up in the margins of the history books.

I’ve written this document, because I noticed that many of the members Edge Analysis Group have questions about futures trading and whether it’s a good idea to start with futures and leverage trading.

That’s why, before I start this document, I want to point out that the financial markets are a zero-sum-game.

For you to make money, someone else needs to lose it and yes everyone is out for your money too.

While we all want to be on the winning side all the time, you will be on the losing side too!

While it’s nice to drive the kids around in a Lamborghini, you need to make sure you feed them too, so never trade with money you cannot afford to lose.

The origins of futures

Well a future is a contract between 2 parties to sell or buy an asset, at a fixed price, at a fixed time in, you guessed it, the future.

In the beginning future contracts were used to hedge against price swings in the commodities market:

Let’s clarify it by using an example of a wheat farmer and an industrial bakery.

Since the farmer can only harvest once a year, same as all his colleagues, he’ll be forced to sell at least some of his harvest at a time when wheat is abundant and the price is probably low.

The industrial bakery at the other hand, needs a steady supply of wheat throughout the year, so even in the middle of winter, when wheat is scarce and the price is probably high.

Here the farmer and the industrial bakery can set up a contract, where the farmer sells a set amount of wheat to the bakery, at a set price at a set date in the future.

This way the farmer is protected/hedged against low market prices and the bakery against high prices.

There is a good YouTube video about the origins of futures,

https://www.youtube.com/watch?v=CC9VeHrI3Es

This will faster and better explain what a future contract in essence is about and why in the open markets it’s used to hedge against price changes.

Now I can almost hear you thinking: “Hold on, this can’t work this way, when I trade a futures contract I don’t want to end up owning an asset!”

Enter derivatives — let’s start the gambling

So as stated, the problem was that the traders on the financial markets, saw an opportunity, but they didn’t want to end up with commodities, but with Dollars for their Lambo’s.

As inventive as traders are, they came up with a whole new market, that trades in parallel with the commodities market.

In their new market they set the price of their contracts by deriving it off the price of the current market price (CMP).

So if the common market price goes up, so does the price of the futures contracts and vice versa.

This way, they have a market to trade, but in staid of ending up with stacks of wheat, they intend to end up with stacks of Dollars.

Let’s illustrate it with another example:

Let’s say the CMP of wheat is now $100 per ton (or whatever metric you use) and trader A expects the price to go up to let’s say $150, while trader B thinks the price will drop to $50. Both these price moves are expected to happen in within 2 weeks.

A contract somewhat like this would then be made:

Trader A’s side:

I, trader A, am willing to pay trader B, the difference between the current price of corn, being $100 and the price of corn in 2 weeks if the price drops.

Trader B’s side:

I, trader B, am willing to pay trader A, the difference between the current price of corn, being $100 and the price of corn in 2 weeks if the price goes up.

So 2 weeks later, the contract has run its course and time has come for either one to pay up:

price went as A expected to $150 => Trader A wins $50, trader B loses $50 (B pays A)

expected to $150 => Trader A wins $50, trader B loses $50 (B pays A) price went as B expected to $50 => Trader A loses $50, trader B wins $50 (A pays B)

As an homage to the inventiveness off traders to make money, they made it even possible to trade these contracts:

Trader A might want to lock in profits at $125 dollars after week one and sells the contract to trader C for $125, who then makes $25 dollars at the end.

Trader B might want to cut losses and sell the contract to trader D for $125, netting him a loss of $25 and trader D will also have a loss of $25 at the end.

So here can see, that no commodity is traded, but they are more or less “gambling” on future price swings, who’s horse is going to be first and who’s last?

Leverage in futures — let’s gamble as pro’s

Here is where the pro gamblers play and Lambo’s are being won, and lost!

Like I stated above, traders in the futures market trade price swings, not actual commodities, so they don’t need to pay the full price of the contract, they just need the money for the price changes.

To go back to the previous example, say that the price of wheat went up with $50, to $150 per ton, than trader B needs to pay trader A $50 and not the full $150.

So when the traders signed this contract, neither of them needed to have $100 in their account, half of it would have been enough, since they were only trading the change.

Now what is leveraging, well in short it’s not only signing 1 contract, but signing for example 10 at a time, while you don’t have the actual have the full amount of money in your trading account.

So in the first example, the price went up by 50% and trader A got $50 to show for it.

Let’s now say that he had leveraged that trade by a factor of 10, so in essence he would have “signed” 10 contracts. If the price than moved up with 50%, he wouldn’t have made $50 but in stead he would have made $500.

What did trader A require to make this trade?

Well when it comes to it, not that much, as long as he is right that is.

So let’s say that trader A only had $100 in his trading account, if he leveraged it times 10 he would have made a whopping 500% (let’s not even imaging that he leveraged x50).

Now what if he was wrong? Well than the trade would be over quite quickly.

Let’s say that before the price went to $150 it first dropped to $90. Well this would’ve been a very big problem for him, because at that point his trading account would have had the staggering amount of $ 0.00 in it.

This is simply because the price moved down with 10%, leveraged by a factor of 10, well you can do the math.

Because this is a high stakes game, you would find it very hard a retail trader to enter this market, or at least in the traditional markets…

Enter bitcoin

As we all know, last year was the year where the cryptocurrencies really stepped out of their shadowy realm and announced itself to the general public.

Because this was/is an emerging market, there were not many opportunities to make money with this, besides buying it and hoping you can sell it on later with a profit.

Therefor people started looking for other ways and they looked to the traditional markets and go and behold, futures trading for bitcoin was created.

At the moment there is a limited amount of exchanges that offer futures trading, of which BitMex is probably the most accessible for most people.

So now we not only have access to a fairly cheap market to trade, we also have access to a market which allows for massive gains, with almost no entry capital.

Now just about anyone who’s interested can start trading futures and potentially make fortunes.

All you would need is some time, a limited capital and you will be living the dream….

Sounds too good to be true?

Well yes, if you are looking for a get rich quick scheme, than it is too good to be true. Because like in the traditional markets, the crypto markets are also a zero-sum-game. For anyone to make money trading cryptocurrencies, someone needs to lose his/her money.

Now add futures to the mix and there is a very real possibility that people are going to lose their money fast, so that only a few “lucky” ones can profit from it and buy their dream car/holiday house/retire/…

Well no, as said, a few “lucky” ones will be able to live their dream. Who are those “lucky” ones, the ones who are willing to put in the effort and educate themselves.

The financial and crypto markets offer great opportunities, for those who are willing to work for their success. There is no golden rule, no shortcuts, if there were everyone would be using them and thus they wouldn’t be shortcuts anymore.

Educate yourself

Although the crypto markets are still in there infants shoes, there is a lot of information out there, because it is all based on the knowledge of the financial markets.

Due to the marvels of internet, a lot of information is ready for you just with the touch of a button, the problem however is that there is a lot of info that is false or useless for you.

To get you started on the search of information, here are some tips: