Another history lesson to get us started on the topic of futures trading. We have a recurring character in our technical analysis series who is a bit of a hero in the trading world.
Sokyu Honma who is famed to be the most successful trader to ever live, the father of the candlestick chart and the earliest master of market psychology traded rice in 18th Century Japan.
At the time rice was primarily traded for coin and was as legit a currency as Bitcoin is today. The samurai class, thought to be one of the highest honours in Japan, were paid in rice themselves.
The regular buying and selling you would see today at a traditional market would happen and would technically be what we know today as spot trading. You buy and sell on the spot with no questions asked or future promises.
One harsh winter in the 1730s hit and resulted in an extremely poor harvest for the rice fields. This news spread throughout Honma’s network of men he was said to have at least one person every 6km from Osaka to Sakata.
As a result the experienced traders of the time Honma included knew there would be a rice scarcity in the coming months and began to stockpile. The demand was always going to be there, after all the samurais had to get paid and more importantly the people had to eat.
Understanding the news from the rice fields, stacking as much rice as possible meant that when the time came and there wasn’t enough to go around, the traders could sell their stock at a premium.
This lead to uproar and a series of riots as conspirators and market manipulators were holding back rice supplies to drive the price. Sounds a little like today…
After a difficult 3 years, the Shogunate (military dictatorship at the time) set a price that was to be upheld for rice. no less than one ryō (gold coin at the time) per 1.4 koku (specific weight), and in Osaka no less than 42 momme(unit of measurement) per koku.
So this set a precedent and out of it emerged the futures market.
Due to volatility in the previous years, rice sellers and buyers we offset this by agreeing on a verbal contract, something to the effect of:
“I will buy 100 kg rice from you for 100 ryo, no matter what”
If there is a great harvest one year then the rice seller is in profit as has lots of rice to sell at a set price. This stops the increased supply of rice from driving the price down for the seller.
If there is a poor harvest one year this would usually drive the price of rice up which isn’t good for the buyer. As they have agreed on a futures contract, the price of rice is fixed no matter the supply.
When assets are volatile like rice was back in the 1700s, these futures contracts protected both seller and buyer against any potential volatility caused by external factors.
What does the word volatility make you think of? Bitcoin…
A more recent example would be what is currently going on at the Suez Canal.
A massive Boaty Mc’Boatface had an intermittent power outage and this lead to it managing to perpendicular park into the middle of the canal. A canal, that carries 10% of the world’s trade and accounts for 7% of the world’s oil…
You can see where this is going.
Let’s say that oil, now is becoming scarce as the supply for the past few days has become very much decreased.
To protect against issues like the Suez Canal and previous conflicts at the Strait of Hormuz a few years back can lead to volatility in the prices of oil.
Traders of commodities such as oil can protect themselves against these volatile prices by agreeing on futures contracts.
“I will buy 1000 barrels of oil at $50 per barrel each month for 1 year”
If the seller agrees to this then no matter the price of oil for the course of a year he sells it at $50 a barrel.
If it is higher or lower that’s okay, as long as his profit/margin is comfortable across a year against a $50 price.
So where does trading come in if this is a way to protect both parties?
Well for some strange innate reason, people like to try and predict the future. It is probably to show that they are smarter than everyone else.
If we bring futures contracts to the cryptocurrency space and in particular Bitcoin, people will predict the price of Bitcoin over a certain time frame.
Let’s use some easy numbers for an example. Rules in this example Bitcoin is $60,000 at the start of April.
I think Bitcoin will go up by April 30th at midnight (1 full month).
You think it will go down by April 30th at midnight (1 full month).
So we make a bet. I will buy 1 Bitcoin from you on April 30th at midnight for $60,000.
If you were right and bitcoin goes down to say $55,000, you have effectively just made $5,000.
If I am right and Bitcoin goes to $65,000 (for example), I get to buy 1 Bitcoin for our agreed price of $60,000, so I make $5,000.
In short, I think it goes up, you think it goes down, so let’s bet on it and see who is right. The difference in price determines how much the other person wins. This agreement is a futures contract.
So you can settle futures contracts in a delivered outcome where in our example you would actually physically sell/buy the Bitcoin.
You can create futures contracts that represent the overall bet. Let’s say this specific contract equates to 0.1BTC/contract. So in our above example, instead of you having to sell me the BTC, we could settle in the monetary value of 0.1BTC which would be 0.1 x $5,000 = $500.
This way, people can enter futures contracts with another party without having to actually own the ting they are betting on.
Perpetual futures contracts (perps) are more commonly seen in cryptocurrency. These are the same as above, you are betting on the price movement of a coin, although in perps you don’t have an expiry time. If your trade is winning, let the winners ride.
Instead of training against one person, the way big exchanges like AAX work, their order books and perp contracts are constantly battling it out against those on the other side of the trade. This way you can keep your position open.
Futures contracts get a bad name in the crypto game and I myself am very torn on the matter. It comes back to the old saying of “with great power comes great responsibility” the issue is, this is crypto, ape’s gonna ape.
Exchanges will offer traders 100x leverage, effectively meaning they can take the same position with 100x upside potential if it comes off… of course there is a catch.
That 100x leverage comes with a price and that price is the smallest liquidation price you have ever seen. Effectively the higher your leverage the higher your chance of geting REKT.
Exchanges love those apes who will cran that leverage up to 100x and gamble (because that is what you are doing) their funds away, all the while fattening the insurance fund and giving the liquidation engine a nice workout.
It is the same reason McDonald’s offer you to go large or why Weatherspoons ask you if you want to double up for £1. People love excess, myself included.
If the option is there, people will always do it. Temptation and greed will always overthrow logic and reason especially when money is involved.
But, there is a place for it. If you can check your self and maybe just turn that dial-up 2/3x, why not.
I must stress if you consistently spot trade at a loss, please don’t go anywhere near leverage trading, especially in crypto, you will lose it all.
Practice, practice and more practice. You can paper trade or better yet try it with a very small SEPARATE bag you have.
To reiterate, keep these trades separate from your long term holds. Do not gamble with your potential freedom. If you are wanting to leverage trade in the futures market, then do so with dirty cash you have to spare.
The best way to keep them separate is to use a different exchange to stop you from getting tempted.
In my opinion AAX exchange has an incredible futures trading system all powered by the London Stock Exchange. Reliable, powerful, tight spread and incredible liquidity.
Oh and you might notice a little less of those conveniently places liquidation engines at work too as it is powered by LSE… Not mentioning any names here…
AAX has supported blocmates from the start and we are very grateful. If you want to give back to us, the best way you could do that is by signing up to AAX using our referral link below.
The next article will be how to set up and execute a futures trade responsibly.
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