Typically, when buying shares of a company on the stock market, traders submit an order to their broker, who finds a seller and facilitates the sale. The same is true for trading cryptocurrencies on a platform like Bitstamp. It is a relatively simple process that is based on the price of the asset at that exact moment. These are known as spot trades.
Futures operate in a different way. They are financial derivatives, named because they derive their value from the price of an underlying asset (like a stock, currency, or commodity). Derivatives do not have any inherent value like stocks, whose value comes from the companies they represent. In fact, most derivatives—including futures—are simply legal contracts between two parties who agree to conduct a trade of an asset at a specific price at a future date.
Futures are derivatives because they are based on a trader’s predictions of an asset’s future price. Traders determine this future price using factors such as the current price of that asset, market trends and expectations, the risk-free rate of return (based on interest rates), and the time until the contract settles/expires.
In general, futures are used for both speculation and hedging. Speculators trade futures contracts to bet on the future price of an asset and apply leverage to increase their potential gains. Others use futures as hedges to control the volatility of their portfolio and protect against large adverse market movements.
Futures trading is available for multiple types of assets, including agricultural products (like corn), energy (oil), equities (stocks), currencies (US dollars), metals (gold), and cryptocurrency (Bitcoin).
Examples of futures trading
Futures trading has long been established for commodities, currencies and indexes (e.g., S&P 500 futures).
By buying a futures contract for commodity, like oil barrels, at $100 in 45 days, traders agree to buy oil barrels at that price then. That agreement remains in place even if the price of the stock goes down to $1 or jumps up to $1000 by the end of the contract.
Of note, the value of the contract may change depending on swings in the underlying asset’s valuation. Therefore, traders can sell their contracts back to the market before they expire for a realized gain or loss.
Because futures are based on more factors than just asset valuations—like market predictions and varying degrees of leverage– the gains and losses might look different than if traders were to trade the underlying asset directly. For example, traders purchasing the E-mini S&P 500 index futures with a 50x multiplier to the underlying index, will gain or lose $12.50 for every $0.25 the underlying S&P 500 index moves.
How do futures work?
Futures trading is usually done through a broker, often the same entity that is used to trade stocks and bonds. Users first have to be approved to use margin before they trade any futures contracts because of its unique risks (more on this below).
Buying a futures contract is a long position, analogous to buying a stock. By entering into a long position, the trader is making an agreement to buy the underlying asset at a future date. This means that as the price of the underlying asset increases, so does the potential profit on its derivative contract—and vice versa. The opposite is true for a futures contract seller, or a trader with a short position. By entering into a short position, the trader is making an agreement to sell the underlying asset at a future date, and accordingly they stand to gain if the price of the underlying asset decreases.
However, on top of the current (spot) price of the underlying asset, futures traders must also consider the time period of the contract (when it expires) and how much leverage they are applying.
There are multiple traditional futures markets for cryptocurrencies. One example is the Chicago Mercantile Exchange (CME), which hosts a large proportion of Bitcoin futures trading. In fact, the CME has supported Bitcoin futures trading since December 2017, and it later introduced trading of Ether futures in 2021.
CME also offers Micro Bitcoin (MBT) and Micro Ether (MET) futures, which are one-tenth the value of each cryptocurrency and increase the ability to apply leverage in crypto futures trading.
Terms of futures: price and date of expiration
Futures contracts have five primary specifications, in addition to the pre-determined date when they expire:
- Notional value: the amount each contract is worth, which is the price of the futures contract multiplied by the contract size
- Contract size: determines the amount of the underlying asset in each contract, such as one-tenth of a Bitcoin or 1000 barrels of oil
- Tick size: the smallest increment that the contract can change in value, such as $1 or 5 cents
- Trading hours: unlike the stock market, certain futures may have extended trading hours overnight or on weekends
- Delivery (or type of settlement): futures contracts can either be cash-settled or physically settled
Futures contracts are legally binding and obligatory, meaning that at expiration, a seller and buyer of a contract must exchange assets.
Most futures trading involves settlement in cash, where the seller and buyer exchange money according to the value of the underlying asset (for example: the cost of 100 oil barrels) at the time of the contract’s expiration.
However, more rarely, futures can be settled physically, meaning the seller of the contract can supply the underlying asset (such as 100 real oil barrels) to the buyer at expiration.
In practice, most traders commonly close their contracts prior to expiration instead of going through the settlement process. For traders who are long a particular futures contract, this involves selling the contract on the open market. For traders who are short, this involves buying the contract.
What are perpetual futures?
Traditional futures contracts are time-limited by definition and thus have an expiration date. If traders want to continue to trade futures over longer periods of time, they must sell their contracts (or let them expire) and then buy new ones, a process called rolling.
Perpetual futures, or perpetual swaps, are similar to traditional futures contracts but without a set expiration. In other words, the contract is ongoing as long as the buyer has not sold it (or been liquidated).
Although the idea was described in the early 1990s, perpetual futures were not introduced until 2016, when the BitMEX cryptocurrency exchange offered them for various cryptocurrencies. Perpetual futures trading has since been adopted by many other centralized crypto services, as well as on decentralized finance (DeFi) platforms like dYdX and Perpetual Protocol.
Perpetual futures use a funding rate mechanism to ensure the contract is consistent with spot market pricing. Funding rates are periodic amounts of an asset paid between short and long traders to allow the contracts to be held indefinitely.
Futures trading risks
Trading any financial instrument involves risk due to uncertain market movement. However, derivatives such as futures can put traders at risk of losing money much more quickly.
In traditional markets, retail traders must be approved by their brokers to trade futures contracts based on their individual financial situation. This is because futures trading involves the use of margin.
Traders typically do not deposit enough cash with their broker to cover the entire notional value of their futures position. Rather, they typically deposit only a small percentage of the total notional size. This is called margin. Margin ensures that the trader has skin in the game and can absorb some level of loss on their position. However, since traders don’t have enough cash to cover their entire position, they can experience losses larger than the amount of funds they have deposited to the account.
The amount a trader must deposit to initiate their position is called initial margin. As the market value of their position changes, traders must continue to keep their account value above the maintenance margin required by the platform, or else they risk liquidation—forced closing of their positions to cover losses incurred through trading.
In summary, futures trading can be more precarious because it can risk an investor losing more money than they actually have.
- Futures are contracts between traders who agree to buy/sell an underlying asset at a certain price at a pre-specified future date; this makes them a type of financial derivative
- Although futures have long existed for commodities, currencies, and other assets, they have more recently been offered for cryptocurrencies by centralized crypto platforms and traditional financial markets
- Perpetual futures are unique to the crypto market, removing the need to “roll” contracts because there is no set date of expiration
- Futures trading carries significant risks due to the use of margin to create leverage