With all of the talk surrounding Bitcoin futures, this might be the perfect time to explain exactly what futures are in plain english.
The financial instrument known as “futures” were developed to help farmers. While futures are tied to all sorts of financial assets and commodities, there primary purpose was to aid the volatile business of agricultural production. Volatility in this context is defined as an unpredictable range of price swings. These price swings to an American farmer can be the difference between feeding your family and going broke.
The average midwest farmer had to guess on how successful his crops, or yield, was going to be in order to calculate revenue and profit. The problem is the farmer’s forecast is going to be high or low depending on factors such as weather. Not knowing whether you were going to make a profit, let alone break-even, is a risky way to operate any business. Farmer’s needed a way to lock in prices to remove some of the unpredictable nature of agriculture and price volatility. “Futures” contracts revolutionized the food industry as it allowed farmers to lock in a selling price at some point in the future-hence the name. Not only did it allow sellers of crops to lock in prices, it also helped buyers lock in prices whom are on the other side of the deal. As no one had a crystal ball to how good or bad the crop season was going to be, these contracts acted as a “hedge” against the unpredictable nature of prices in agriculture. A wide range of raw materials and foods use futures contracts to manage prices, from crude oil to pork bellies.
For example, if bad weather created less yield for soybeans this would typically create less supply and thus higher prices. If the farmer “or seller of the crops” used futures or forward contracts to lock in a price, they risk not being able to benefit if the price of these crops suddenly start to rise. This method of doing business dates back centuries, and the introduction of contracts simply made these agreements legal obligations.
Today there are hundreds of futures products that represent or “derive” their pricing from all different types of securities which go by another name , “derivatives“. While this word causes some people to cringe for being the root cause of the subprime mortgage crisis, derivatives themselves are only as stable as the underlying asset it represents. Company stock options are another example of derivatives, where the value is “derived” from the price of the company stock. I don’t imagine Mark Zuckerberg would have anything negative to say about the derivatives that represent Facebook’s stock price.
In essence Bitcoin futures are just like any other futures or derivatives contract, where it is a contract to purchase the underlying asset at a specific price. An important point however is that the Chicago Mercantile Exchange (CME), nor the Chicago Board Options Exchange (CBOE) will deliver any Bitcoins to buyers or seller. These contracts will be settled in cash, similar to the S&P 500 futures contracts. Futures contracts are created with a monthly expiration. A speculator has to make sure she has locked in a better price lower than the current market price to make money prior to this expiration date. Since Bitcoin futures are settled in cash, any price advantage is paid directly to her account without the exchange or delivering of actual Bitcoin.
The CME futures contract is based on five bitcoins (Bitcoin Price x 5), where the CBOE futures contract is based on 1 Bitcoin (Bitcoin Price x 1). Commodity futures contracts all represent a specific quantity per contract such as bushels, tonnage, or barrels. For example an oil futures contract represents 1000 barrels of oil, or 42,000 gallons. While bitcoin futures are settled in cash, meaning no actual delivery of bitcoin is involved, most commodity futures contracts support delivery of the commodity.
A very dangerous element exists where a buyer is obligated to cash settle or purchase the commodity. Forgetting about this obligation may cause several oil tankers to arrive one day seeking to delivery your 1000 barrels of fresh crude oil. For this reason, futures are not anything to play around with like day trading stocks, as they represent legal contractual obligations to buy or sell bulk commodities.
To weed out non-professional traders, the CME requires a large 50% down payment for Bitcoin futures contracts, which based on today’s closing price represents a $32,000 deposit for five Bitcoins. The US exchanges do not openly support or refute Bitcoin, but provide futures contracts as a service to financial firms, or crazy individuals looking for to play with a $32,000 slot machine.