What the Hell is a Futures Market Anyway? - Beginners Guide
Futures Markets - Beginners Guide
Recently a good friend of mine decided to take the plunge into Cryptocurrency. He's never been big into investing or markets so when he started hearing about the Bitcoin Futures Markets he was a little confused. I wrote this explanation in an email to him a couple days ago, and after reading tons of questions around Steemit regarding the upcoming Futures Markets I thought I better share this with this awesome community. This is an extremely simple explanation that doesn't take a lot of things into account, but I think it will help those around here that have never even ventured near a market, let alone a Futures market. You experienced traders out there feel free to add any addition clarifications or tid bits you might have in the comments! Hope this helps a few people out there.
What the Hell is a Futures Market Anyway?
Great Question new investor! A Futures Market is a market that is typically used to hedge risk and speculate on prices of stocks, currency, metals, or really anything that is traded through a certified exchange like the Chicago Mercantile Exchange better known as CME. The easiest way to describe Futures and Futures Markets is by giving you a simple, real life example. The best examples always seem to utilize crops, as crop pricing can be fairly volatile. We'll use crops in our example too.
To start, imagine you are a corn farmer in the United States. You start growing your crops in June, and because there isn't much corn available in your market at that time, the price for a ton of corn is high, let's say $500/ton. You love this price as a farmer because it covers all of your costs and still leaves your family with a little bit of profit, fantastic news for you!
Now you're a savvy farmer, this isn't your first time around a combine after all, so you know that there are going to be a lot of other farmers that will also love this price. You also know that those Brazilians down south have so much corn they'll love the price even more than you, so much so that they're willing to ship their corn up to the US just to sell it at that price.
Well shit, now that everyone and their mom is going to be bringing corn into the market in August there is no way in hell that price is going to stay at $500/ton. The market is going to have an overabundance of corn!!!
With that much corn in the market prices will certainly drop, maybe even so far that they don't even cover your farming costs! At that price your family will lose money on this years crop! There is no way you can take the risk of that happening. But what is a simple corn farmer to do!?!?!
Enter the Futures Markets
At this point in our example Futures Markets have come into play. In a Futures Market you are able to buy or sell a Futures Contracts! As a farmer you sell Futures Contracts for your corn at the amazing future price of $500/ton...today! The buyer of that contract is buying the obligation to buy your corn for $500/ton, no matter what the actual price of corn is at the time the contract expires, in this case we'll say that contract expires in August. Boom, you just locked that awesome price of corn you love in June, before your corn is even grown! When August comes around you'll be swimming in guaranteed profit, no matter what happens to corn prices! Awesome stuff, I know!
Now, why would anyone ever want to buy that Futures Contract, won't they just be buying corn for more than it actually costs? Well, keep in mind no one really knows with 100% certainty what the real future price of the corn will be. The person that buys the Futures contract from you in June is actually speculating on the price of corn. In buying your Futures Contract from you, they're betting that the price of corn will be higher by the time the contract is up, meaning they'll be getting your corn at a discount. Maybe there will be terrible weather and most of the corn in the Country will die off shrinking the supply, or perhaps Elon Musk will invent the corn powered battery for his new Teslas and everyone wants as much corn as they can get their hands on jacking the price way up to $2000/ton. It doesn't matter how it happens, but if the price of corn goes up the buyer of your Futures Contract has now made money by locking in the $500/ton price in June.
One of the last items I want to share with you about Futures Markets is there usefulness in hedging investment risk. I prsonally believe there will be a decent number of new bitcoin investors that will enter the market simply because they are finally able to hedge the risk of owning bitcoinnow.
So, how does hedging risk work in Futures Markets? Well, in this case let's move away from our corn farmer example and head on into the Bitcoin markets. To start let's define the biggest risk related to owning Bitcoin. The bigges risk of owning Bitcoin is that the value of Bitcoin could always drop to $0 and poof! all the money you invested into that coin is gone, Bitcoin is worthless.
Now whether that money you invested came from Fiat currency, or buying equipment and energy to mine Bitcoin, it doesn't matter, all of that money could disappear in the blink of an eye, and that risk is so so high because of the crazy volatility we see in the Bitcoin market.
Enter the Futures Markets, Pt. 2
The easiest way to hedge, or limit, this risk is to utilize the Futures Market. If I am a whale, and I own a ton of bitcoin, I don't like all that risk, I want a way to guarantee that I will always be in profit. Again, just like we did when we were a corn farmer we head to the Futures Market and sell a Futures Contract for our Bitcoin at today's price. If today Bitcoin is trading at $15k we sell out Futures Contract saying Bitcoin will be valued at $15k, 3 months from now (the time period can vary depending on the market and contract). Since we're geniuses and we got into Bitcoin back in 2010 we have now locked in a profit if the price goes down over the course of those 3 months. Now at the same time we have also limited our profit if the price of bitcoin goes up past $15k over the course of the next three 3 months, but because we actually own the bitcoin we will still always have that value of our coin, and could always sell it to pay the Futures Contract buyer the additional money above $15k that the Bitcoin value rises too.
The thing to remember with Bitcoin Futures Markets, is that there will be no actual selling and buying of Bitcoins. These contracts completely cash bets based on the value of Bitcoin. The only real Bitcoin sales/purchases that will come into play with the Futures Markets is when someone is using Futures to hedge Bitcoin ownership risk, or if they are performing arbitrage to take advantage of pricing discrepancies between markets, but that is a story for another post.
Ok, to bring everything together lets talk about if you should be making moves in the Futures Market. First off, if any of the above was brand new to you, the Futures Market is probably not for you. Also, if the above wasn't new to you, but you are confused by the words Contango and Backwardation, the Futures Market is probably not for you.
So who should be using the Futures Market? The people that these markets really makes sense for are those whales that have deep enough pockets that they need to hedge their risk, or those that have enough money they can cover any huge losses they might incur from crazy price action, and YES, the losses can be huge if the market makes an enormous move in one direction. Hedge Funds and Institutional Investors that have BILLIONS of dollars at their disposal definitely fall into these categories.
The other use for futures markets are the speculators, again speculators with deep pockets, those that believe the cost of something will be more than futures contract price they bought. Remember they are taking a gamble betting the price will go up.
That basically sums it all up...Now if we want to get into the intimate details of stock market futures there is a whole added complication of fees, dividends, and other costs to get into. These factors can have big impacts on the moves that traders make, including forcing them to roll Futures contracts over from one month to the next.
Those of you that made it this far...Thank you so much for reading! I hope you all learned something. For you more experienced traders please feel free to add any comments, tidbits, tips, tricks, advice, further examples to the comments below. Hoping those people new to trading will be able to use this little beginners guide to help them understand the new world Bitcoin is entering.