Futures fundamentals: Understanding the basics
by Coinbase Derivatives LLC
In this article we’ll break down the basics of futures so you can start participating in the futures market. Here we’ll dive into some of the key components of futures and how they work.
What are futures?
A futures contract is an agreement between a buyer and a seller to exchange an underlying asset or index at a predetermined price at a future date or expiration of the contract.
In short, it’s a contract that ensures that both parties can express their views on the future price of an asset.
For example, Bitcoin trades 24/7, which means that its price is always moving. An investor can take advantage of a futures contract to hedge the price of their Bitcoin.
The long and short
The futures market offers opportunities for investors to engage with a wide range of commodities and equity indices in a couple different ways: going “long” or going “short.”
What is going long?
Going long is just like buying a stock or an ETF. If an investor anticipates the price of an asset to rise, they might buy a futures contract on the asset in hopes that the price will increase between the initial purchase and the expiration date. They would be able to sell at any time before expiration and, if the price did increase, they would make a profit.
What is going short?
On the other hand, if an investor expects the price of an asset to fall, they might go short, selling a futures contract on the asset. Long or short, investors can trade out of their positions any time before the contract expires or hold until expiration, receiving or paying the difference between their trade price and final settlement price in cash.
What are leverage and margin?
Going long or short requires an investment that, in the futures market, is made with margin embedded in the futures contract itself.
The margin on a futures trade is the deposit required to open a position on the contract. The deposit amount will vary depending on the cost of the underlying asset and your broker’s requirements. It is also subject to increase while you maintain ownership of the long or short position.
This deposit, however, has leverage. Leverage allows you to control a larger market position with that smaller upfront capital deposit, giving you more exposure to potential gains or losses.
Let’s take a look at examples of going long and short with margin and leverage.
Example: Going long
An investor wants to go long 10 nano Bitcoin futures. Each contract has a notional value of $1,000. This means that even though the price of Bitcoin is $100,000, each nano Bitcoin futures contract, which represents 1/100th of a Bitcoin, allows an investor to control $1,000 worth of Bitcoin per contract.
To open the position, the investor is required to put down 25% of the notional value as the margin. The total notional value of the 10 contracts is $10,000 (10 contracts x $1,000 each). With the 25% margin requirement, the investor must put down $2,500 (25% of $10,000) to control the position.
If the notional value of each contract rises to $1,500 before the contract expires, the investor can profit from the price increase when they close their position. The new total value of the 10 contracts would be $15,000, resulting in a profit of $5,000 ($15,000 - $10,000).
However, leverage also increases risk. If the contract price falls, the investor could lose their initial deposit and might be required to cover any additional losses. That said, most futures brokers would likely close out the position before it creates losses above the initial deposit, which they would specify in their specific risk policies.
Example: Going short
Now, let’s say that the investor believes the price of Bitcoin will drop and decides to go short those same 10 nano Bitcoin contracts instead.
Again, the notional value of the 10 contracts is $10,000 ($1,000 x 10), with an initial margin of $3,000 (30% of $10,000) required to control the position.
If the notional value of each contract drops to $500, the total value of the contracts would decrease to $5,000 ($500 x 10). To close their position, the investor would buy back the contracts at the lower price, locking in a $5,000 profit ($10,000 - $5,000).
Recap
Key terms
Going long
A position an investor takes if they anticipate the price of an asset to rise, much like buying a stock or an ETF.
Going short
A position an investor takes if they anticipate the price of an asset to fall. They would sell a contract in hopes of repurchasing at a lower price later.
Leverage
The ability, via margined futures, to control a large position with a relatively small amount of capital, or initial margin. Leverage provides traders significant exposure to an underlying asset without needing to pay the full value of the contract up front.
Margin
The deposit required to open a position in a futures contract. Typically, the margin is a fraction of the contract’s notional value.
Exposure
The degree to which an investor is affected by changes in the value of a contract’s underlying asset. Essentially, exposure represents the amount of risk—or potential profit or loss—that a trader could face due to market fluctuations.
With the key characteristics of margin and leverage, as well as the ability to take both long and short positions, futures offer people accessible opportunities to invest.
The risk of loss in trading futures can be substantial. You should, therefore, carefully consider whether such trading is suitable for you in light of your circumstances and financial resources.
