There are many ways to trade or invest in bitcoin. In this post, I’ll explain how bitcoin futures contracts work.
What are futures contracts?
A futures contract is essentially a forward contract that can be bought or sold on an exchange.
A forward contract is an agreement to buy or sell X amount of an asset at price X in the future. This allows people to “lock in” a buy or sell price of an asset in the future to protect them from the risk of an unfavourable price change. The example in the box below explains this concept in more detail:
Forward Contracts: the wheat farmer and the baker
A wheat farmer sells wheat to a baker at the end of the wheat harvesting season. The baker uses the wheat to make bread. The price of wheat at the end of the harvest season affects the wheat farmer and the baker differently:
- If wheat is cheap in the future, the farmer loses out when he sells it to the baker. The baker wins because he can buy the wheat cheaply from the farmer.
- If wheat is expensive in the future, the farmer makes more money when he sells it to the baker. The baker loses out because he has to buy wheat at the higher price.
In this case, wheat is the underlying commodity. Its price fluctuates up and down all the time, yet the bakers’ bread stays the same price all year. This is made possible through forward contracts.
Say the baker wants to buy 10 bushels of wheat from the farmer in two months time. He could enter into a forward contract with the farmer to buy those 10 bushels of wheat at a price they both think is fair. Now the farmer and the baker have “locked in” the price of their future business deal.
So that’s the basic idea behind a forward contract—the baker and the farmer are hedging price risk.