Futures, simply put

Tuesday, 11 December, Year 4 d.Tr. | Author: Mircea Popescu

A future contracti is quite exactly what the name says : two parties agree as to the disposition of some thing of value in the future.

They are very useful practically, because they allow the regulation of production and consumption. Say Moe is a blacksmith. One day in walks a customer and orders fifty swords, to be delivered one a day for the next seven weeks. Moe has some iron stored in his shop, but it would be only enough for about twenty swords. He could go buy more iron right now, but for one he doesn't need it yet, and for the other his iron storage is already 70% full, so he can't very well add another 100% cause it won't fit. What's he to do ? Moreover, his sword making is only profitable for him if the price of iron is under X. What if next week the king decides to declare a war or something and iron prices explode ?

On the other hand, Joe owns a mine. His mine outputs about the same quantity of raw iron every week, the problem is that some weeks there's five times as many customers as he can deliver and some other weeks (and sometimes months) there's none. He can't store month's worth of production because for one there isn't room, for another it goes bad and for the third he needs to eat every single day, plus the workers need to be paid. What's he to do ?

Well, obviously, Joe and Moe could get together, sign a contract for future delivery of iron, say enough for twenty swords two weeks from now. Joe now can rely on his miners being paid and his product being delivered for sure, Moe can rely on having his iron and knowing how much it will cost him (thus being able to meaningfully quote to his customers in turn) and everyone's happy. Moe pays Joe a small consideration for the contract much like you might put a five dollar reservation on a hundred dollar baseball ticket or something and they part ways.

This would be the notional and historical starting point of the futures contract. It is still in use today, but it is called a "forward" to distinguish it from a futures contract "proper", which is highly standardised. Indeed, as time went by and a ton of miners entered into a ton of contracts with a ton of blacksmiths about tons and tons of iron, coal, tobacco, nubile young women, fowl and whatever else is mined out of the Earth they starting having disputes. These disputes ended up in court. It was a waste of time for judges to always try to figure out each contract as an individual thing, and so to save everyone's effort contracts were standardised : monthly deliveries rather than any random day, fixed quantities, specified qualities, grades, types and so forth.

Soon enough the newly standardised instruments were being traded in dedicated spots that had the means of making sure you're sticking to the standards (such as for instance by comparing to some other contract) because entering into a nonstandard contract might potentially expose one to more enforcement costs than the contract is worth (a very economic centralisation effect, incidentally).

These in turn created the speculator, who bought or sold contracts with no intent of ever actually taking the iron and the cash-settled futures were ready. Indeed, since it's irrelevant to a blacksmith who delivers him his iron, a contract for delivery under market price carries a value as any negotiable instrument. Thus if someone bought iron today for delivery in a month at two coins to the nugget and in a week the king really does declare that war and iron goes to three coins and a half the nugget, that someone can easily claim a coin and a half for himself.

So basically : selling futures means you are promising someone to deliver something, cocoa, goose feathers, what have you. Buying futures means you are being promised to receive something, very small rocks, round dice, who knows. If the price of the something goes up, whoever sold the futures loses money and whoever bought them makes money. If the price goes down whoever sold the futures makes money and whoever bought them loses money.

There is one important difference with MPEx futures, and that is their BTC denomination. Let's work with the X.EWTI to better understand what's going on.

Lowest ask at this moment is 0.06666667, for 439 contracts. Suppose you buy a hundred, that costs 6.66666700 BTC, which would imply a WTI price of about 88.66 USD. If the BTC doubles and WTI stays the same you are unlikely to be able to sell the X.EWTI for more than about 0.033, which means you lost 50% of your 6.66666700 BTC even though WTI stayed the same. If on the other hand BTC stays the same and WTI doubles you will likely be able to sell your 100 contracts for ~13.3333 BTC, thus doubling your money.

Because the references are all expressed in USD whereas we are all playing with BTC, we see what is called "currency risk" IRL. If you buy a house in Europe for 50`000 euros and next year the house value has doubled to 100`000 euros but the euro has halved in value you haven't really made anything (other than in the eyes of the taxman, of course).

For the prudent investor there exist two ways to mitigate this problem. One is to enter in buy/sell paired trades. As long as you buy 5 BTC worth of contracts in one thing and you also sell 5 BTC worth of contracts in another thing your BTC risk is reduced to 0, and you are in effect trading relative pairs. Say you buy X.INDQ (Nasdaq 100) and you sell X.INKG (Nikkei 225). Should an earthquake hit Japan this will likely mean that X.INKG is worth less when compared to X.INDQ, and so you make some BTC. If on the contrary horrible job reports come out hurting the Dow the opposite is true (X.INKG is worth more in terms of X.INDQ) and so you lose some BTC. However, should the BTC double or halve this would have absolutely no effect on you.

The other is to enter offsetting trades, such as for instance buying options (CALLs insure against BTC going up, PUTs insure against BTC going down), directly trading the currency (if you buy BTC and buy futures to the same value or if you sell BTC and sell futures to the same value you're also zeroed out) and so forth. Icbit.se offers a BTC/USD future which I wouldn't however recomend.

I hope this cleared it up, but if not don't hesitate to ask questions below.

  1. Commonly called "futures" the way John is called Johnny. []
Category: Actiuni si Optiuni
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