Engineer in fintech series: Futures Trading through the eyes of a 10 year old.

If you have ever thought of making money online, then you have definitely thought of crypto trading or forex trading or both. If you are like me, you have probably lost money doing both. But really what is this future trading we have been trying to do? Is it bet9ja wey dey disguise?

I recently started a role as a banking business analyst and I am loving it. Just one week in, i immidiately loved the concept of futures trading as a derivative instrument. No! I'm not talking about dy/dx haha so, fear not. Yes! futures trading, both in crypto and forex is a trade of derivatives. so, hold my hand and let me take you through a brief introduction to futures in the financial market.

Before I get too serious, I remember my first valentines day gift from my sweet heart back in the days- correct Timberlands - Reigning shoe at the time. Everyone knew it was costly. about #8000 at the time. But on delivery, it was a bit undersize, so I decided to sell it. Guess who decided to buy it? my cousin who was outside the country at the time. He said he was coming back for the summer, which was about 5 months away in July. Now, I had other people willing to buy this shoe at the time but I was going to scam my cousin. So, I agreed with my cousin that he would pay me 9k when he comes back to naija for the shoe. Anyways, I don't need to tell you that we got into a fight when it was time for the contract to be honored lol. But not for the reason you might be thinking. we fought, because, by July, the shoe price had hit 12k probably due to inflation. and my cousin still wanted to pay 9k.

This kind of agreement is a forwards contract between me and my cousin. And a futures contract is, in simple terms, a forwards but standardized by exchanges. So, I'll describe this as a futures. So, It would be called a July futures contract, because The delivery month is in July. I, the seller, have what is called, the short futures position, while my cousin, the buyer, has the long futures position. The 9k agreed is the July futures price of a timberland as fixed by me in February. Now, ideally, if my cousin buys the shoe from me, he can resell the timberland for 12k, and make 3k as gain. But, remember, that it was possible that the price of timberland falls after it wasn't in vogue anymore, to 5k for example, I then make extra 4k than I could have made from the sale.

Can I tell you a little about financial instruments? just to give this discussion a bit more solidity. Of course I can! Financial instruments are basically money in a contract. Easy way to imagine this, is a cheque. The bank is obligated to honor the cheque and pay money because it is a contract - Contract of money. But even simpler, When I give money to my bank to keep, it is a deposit contract. Financial instruments are therefore divided into either cash instruments (deposits, loans and securities/stocks. Basically our daily bank transactions), foreign exchange(currency swap, spot) and derivative instruments which we are focusing on.

Derivatives, as the name implies, is a financial instrument whose value is dependent on another underlying asset. They are either traded off the counter or in exchanges. off the counter refers to trading with banks et al. So, let us focus on Exchanges. Just think of exchanges as something like binance, coinbase and co. Remember though, the crypto trading of derivatives is slightly different from what actual trading of derivatives are, but the basic principles apply. Two major derivatives traded in exchanges are: futures contracts and options. we are only discussing futures right now. so, let's continue...

I'm sure, you might be asking, How on earth does this futures concept prove useful in real life? Well, in reality, take for example, someone rears a herd of cattle and he knows that his cattle would be mature by June. It is fair to say, that as at January, he must already be expecting a certain amount as profit from the sales, but he still doesn't know if the price of cattle would fall before then, making sell even at a possible loss. On another hand, a rich man has a burial to plan for, in June and he already has a budget for cows. but there is no guarantee that the price of cattle would not rise due to transportation costs or whatever else. In this case, the both parties can ease their fears, by participating in a June futures contract, that ensures, the farmer gets a certain amount from the sales, while the man planning the burial, can be sure of how much he would spend. Remember though, at this point, that this is still a forwards because there was no exchange acting as a middleman and facilitating this trade. The presence of an exchange, alongside other standardized policies and features, changes this to a futures trade.

This description forms the basis for understanding futures and is the earliest form of derivatives trading ever practised. Obviously, there are differences between this description and what is practised in crypto futures or Forex futures. This is because, the average futures contract trader is a type of trader called a speculator. This brings us to the 3 types of futures contract traders:

1. The hedgers- They are firms trying to mitigate risks just like in the example above. now, notice that the hedger could be in a worse position than if he didn't buy the futures contract. for example, assuming the farmer agreed 90k as price per cow in the futures contract, if the cow price from the above example, in June is 100k, he loses 10k per cow compared to if he hadn't taken the futures short position. while, if cow price is 80k, he gains 10k per cow compared to if he hadn't taken the futures contract.
2. Arbitrageurs- They basically trade in different currencies or locations and take advantage of difference in price.
3. Speculators - People now trade futures contract based on what they predict future prices to be. for example, if bitcoin is 40k, but I think bitcoin would be say 42k by the end of the day, I can buy a futures contract - long position, since it means that bitcoin at 42k by end of day, would still be bought by me at 40k. Meaning I just make 2k profit by selling at the spot price. But what if bitcoin crashes? due to Elon musk's tweet perhaps. well, your guess is as good as mine. Losses galore. The opposite is true for the short position or selling position. one more thing to note, is that exchanges close accounts daily; meaning you can withdraw profits at the end of each day. but that might be too much details for an intro article.

Now, there are more concepts such as margins, how to close a futures contract etc. which would make the picture clearer, and I may write on them in the future, but for now, through these general overview, you now know that you simply are a speculator as a forex or crypto trader. And since nobody can always predict the market, its quite simply a gamble.

How much of a gamble though? we will explore that soon!

Let me know your thoughts if you read till this point. see you in my next article.