1. Futures Contract
Futures trading is an agreement to buy and sell a product at a fixed price at a certain time in the future. Because of the promise to sell at a predefined price, traders can avoid losses that can be caused by spot price fluctuations. Although it started with the purpose of risk avoidance, it has developed into high profit and high risk investment product by actively accepting the risk using advanced financial techniques like leverage.
Traditional futures contracts contemplate that the agreement will be fulfilled by actual delivery of the product at a future date, while other contracts allow cash settlement in lieu of delivery. Most contracts are liquidated before the delivery date.
Traders participate in futures trading because of the many advantages of futures trading. First, futures trading has a hedging function. In other words, by reducing the risk of spot price fluctuations, a stable market can be formed. Second, futures trading expands liquidity in spot markets. This is because the hedging function of futures trading reduces the investment risk of the spot and increases the inflow of new investors. Third, it serves as an expectation of price by presenting the expected value of future spot price. Fourth, futures trading can be a new means of investing by providing leverage that allows you to trade large amounts at low capital.
Khan Academy has very comprehensive lectures on futures investing for those wishing to learn more.
2. Futures Outline
Spot contract is traded in a simple manner, buying at low price and selling at high price, but Futures have introduced new concepts because of the different forms of contracts. Here are the important and typical futures trading terms. Click on the subtitle to jump to that section.
- Open/Close Position : There is a concept of Buying/Selling in the Spot, while there is a concept of Open/Close in the Futures.The Open/Close positions represent the beginning and end of the contract.
- Long/Short Position : Since the spot price at the time of promise and the spot price at the future may be different, the concept of Long/Short has been introduced in predicting future price.
- Maker/Taker and Ask/Bid : It refers to the type of trader participating in futures trading and the type of order traders make.
- Leverage : As futures trading changes as a means of investment, the concept of Leverage was introduced to get lots of profits with small amount of capital.
- Margin : In futures trading, the concept of Margin was introduced to ensure an uncertain future.
- Profit and Loss : It is the profit calculation method of futures trading.
- Liquidation Price / Bankruptcy Price : Liquidation Price and Bankruptcy Price are standard prices to inform the risk of Margin Call.
- Margin Call / Auto-Liquidation : Margin calls and Auto-Liquidation are automatic settlements when you can not maintain a Maintenance Margin.
- Index Price : In futures trading, you need a standard price to compare the price of the spot and the futures. Index Price is an indicator of spot market prices.
- Settlement : Futures contracts have an Settlement date concept to complete transactions at a future point in time.
3. Contango and Backwardation
In the case of futures contracts, since the transaction items must be held until a certain time in the future, the storage costs and interest expenses are added to the spot prices. Thus, there will be a price difference between the spot and the futures. This difference is called Basis.
- Basis : Price difference between the spot and the futures
In futures markets, there are two types of market depending on the Basis, that is, the difference between futures and spot prices.
- Contango : The market state that Basis is positive(the futures price is higher than the spot price)
- Backwardation : The market state that Basis is negative(the futures price is lower than the spot price)
If the market is normal, the futures price is higher than the spot price, and the farther from the Settlement date, the higher the price. That's why Contango is called as a normal market. On the other hand, in an abnormal market, ie, the Backwardation market, spot prices are higher than futures prices due to market imbalances such as short supply shortages.
On the Settlement date of the futures, either the Contango market or the Backwardation market, the price of the future and the spot become the same, and the Basis becomes zero.
Nexybit provides Index Prices extracted from four spot exchanges(Bitstamp, Bitfinex, Coinbase and Kraken). You can do analytical trading with this. The Index Price is displayed just below the Last Price in the Order Book.