Financial markets are full of weird terms. From bullish and bearish markets to options and futures, the load of unfamiliar words and expressions is so heavy that can easily confuse a newcomer. By the way, all these seemingly complex terms have practical functions and if you understand the concept behind them, you will get along with them more easily. In this article, we will go through one of these confusing but important concepts called “future contracts” or “futures”. Stay with us up to the end of this article to figure out what a futures contract is and how you can use it.
What are futures?
A futures contract is a contract between two parties through which an asset will be bought/sold at a specific price at a specific point of time in the future. As its name suggests, its biggest difference from a spot trade is that it is executed in the future, not at the time of the contract being made.
You may ask yourself why should one make a contract to do a trade in the future. Why shouldn’t they wait and make the trade when the time comes? We will answer this question with a non-crypto example. Imagine a baker predicts the price of flour is going to increase. In this situation, he makes a three-month futures contract with the corresponding company and prebuys 1000 bags of flour. He pays the amount instantly but receives the flour three months later. However, if the prediction is precise, this person will make a good profit.
This example may be different from what exactly happens in the crypto market, but it fairly clarifies the concept. Now, let’s dive into the crypto market and investigate the futures contracts in this market.
Futures have two types: “long” and “short”. In the long position, the buyer agrees to buy the asset at a predetermined price in the future. On the other hand, in the short position, the seller agrees to sell his/her asset at a predetermined price in the future. Futures contracts are very common in the cryptocurrency market. We will explain Bitcoin’s futures in the next part, but the explanation is applicable to all cryptocurrencies.
What are Bitcoin’s futures contracts?
Bitcoin’s futures let you trade bitcoins you don’t actually have. They are done through cryptocurrency exchanges and brokerages. Therefore, if you want to make futures, you should first choose a cryptocurrency platform that supports this feature. Another important concept you should learn about is “leverage”. Leverage is the amount you borrow from the exchange, and is usually depicted in percent. The amount of leverage is usually determined by the users, but it also depends on their initial asset, or their so-called “initial margin”. Initial margin refers to the amount required by the exchange to initiate a futures position.
Imagine you predict the bitcoin price to increase. In this case, you can borrow some bitcoin from the exchange and enter a long position. You can use a 25% leverage, meaning that you borrow 25% of the amount you have from the exchange. If your prediction is true and the price really increases, you can pay your debt and earn the remaining profit. It is obvious that your profit, in this case, is more than when you had not borrowed this amount.
However, everything doesn’t always go well. The profit is only gained when you have a correct prediction. If your prediction proves wrong and the price goes the opposite way, your whole asset is at the risk of “getting liquidated”. Liquidation happens when the price decreases to a level that the exchange believes you will not be able to pay your debt. In this situation, it automatically takes your original asset in return for the amount it had lent you.
The opposite of what we explained up to now works for short positions. Short positions are used when you predict the price will go down. In these situations, you borrow some bitcoin from the exchange and sell it instantly. Then when the price decreases, you can buy more bitcoins, pay your debt, and hold the remaining amount. Liquidation also happens in short positions. If your prediction goes wrong and the price begins to increase instead of decrease, the exchange will liquidate your initial asset.
In simple terms, using futures is a risky activity and is considered a form of speculation. Its potential risks are as significant as its potential profits. If you do well, your profit is much higher than the normal state and if you make mistakes, you may experience irrecoverable losses.
How to minimize the risks of futures contracts?
The best way to minimize the risks of a futures contract is to set a “stop-loss order”. A stop-loss order is an order that automatically terminates a futures contract under certain conditions. If you have entered a long position, you can set a stop-loss order and require the exchange to terminate the contract if the price decreases to X. In case you have entered a short position, you can set a stop-loss order and require the exchange to terminate the contract if the price increases to Y. Using stop-loss orders is the best way to minimize the risks of futures contracts and is highly recommended for inexperienced traders.
We tried to explain the underlying concept of futures in the simplest terms in this article. Now you know what futures are and what functions they serve. As the final point, we would like to insist that futures are only appropriate for professional experienced traders. Even these users can also experience losses. Therefore, we suggest that you use stop-loss orders even if you are an experienced technical trader and have had lots of successful trades.
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