Futures Markets and Leverage Trading (ELI5 Edition)

Since we’ve been in a bear market, BitMex has been crushing it in terms of volume, and that’s for one reason and one reason alone: Derivatives.

Everyone understands the basic concept that ‘shorting’ something means gaining profit from the price going down — but not many understand EXACTLY how this works.

So, the purpose of this article will be to provide you an in-depth ELI5 (Explain Like I’m 5) guide to the Futures Markets and Leverage (Margin Trading).

Futures Markets and Margin Trading: ELI5 Edition

Check Out This Base Example (We’ll Be Using This Throughout the Article)

• Let’s say Bitcoin = $1.
• Let’s you think it’ll be worth $5 in 7 days.
• Someone walks up to you and says “Hey, in 7 days I’ll sell you this Bitcoin for $1, no matter what it’s actual value is on that day. However, we only have a deal if you promise to buy that Bitcoin for $1, no matter what.”

That’s a basic futures contract in a nutshell

If the price is $5 seven days later, you got one hell of a steal because you get to now buy a Bitcoin for $1.

If the price of Bitcoin goes down to $0.25 though by the end of that seven-day period, you’re screwed because you’ll still have to pay $1 for something that costs $0.25

-In the hypothetical scenario I wrote above ^ either you or the other guy is going to come out a ‘winner’. Obviously, what makes you a ‘winner’ in the situation is who gets the better dollar value.

Understanding How Cash Settled Futures Work

So a lot of futures exchanges don’t actually use real bitcoin for these trades. Instead, they are cash-settled.

“What does this mean?”

1. So let’s go back for a second. Johnny agrees to sell you a Bitcoin for $1 seven days from now (a week from today’s date) and you agree that you will purchase a Bitcoin from Johnny a week from now.
2. He must sell it for $1 and you must purchase it for $1 no matter what the price of Bitcoin is on that day (per our hypothetical scenario).
3. Let’s say that Bitcoin is at $4 that day. Instead of Johnny actually selling you that Bitcon for $4, he would just give you $3 instead. That’s your profit from the trade. This basically cuts out the step of you the physical bitcoin and going to an exchange, then selling it to actualize your profits.
4. Now let’s imagine that the price did not go up seven days from now and it dropped to $.25 instead of $1. You’ll still have to buy it for $1 from Johnny that day. However, you can pay him $0.75 outright rather than just giving him the physical bitcoin.

This is how futures exchanges work for Bitcoin (in most cases) — including for the CBOE and the CME (those two institutional futures’ markets in Chicago).

That’s why futures are called ‘derivatives’ because the market itself derives from the underlying product without involving literal trading of the asset itself.

Here’s How Margin Trading Works

-Let’s say you’re a really good trader and you feel like you’re a genie when it comes to charts. You are 100% confident that the price of Bitcoin will go up in 7 days (from the starting price of $1).

-However, with only $1, you don’t really have a lot to gain. The price of Bitcoin may only be $1.10 in 7 days and that’s hardly anything for you.

-So you come to me. I’m a broker. You ask me if you can leverage 10x on your contract. This means that you’ll give me however many contracts that you have and I will let you trade 10x that amount.

-In this fictional example, you can only afford 1 contract but I still agree to allow you to leverage it 10x.

-Remember, each contract is $1. So with 10 contracts under your belt you essentially put up $10 on this trade instead of $1.

-The advatange here for you is that you get to take the same profit off of every contract.

-Remember our example where the price went to $4 in seven days? And since Johnny had agreed to still let you buy it for $1 on that day no matter what, he gave you the $3 as your profit instead of an actual Bitcoin (which you would have resold for $4, giving you $3 of profit anyway since you started with $1 originally).

What happened between you and Johnny was for just 1 contract.

-But let’s say Johnny came to you and said, “I agree to sell you 10 Bitcoin [10 contracts] next week at the price of $10. But you must agree that you have to buy those 10 Bitcoin from me seven days from now for $10 no matter what the price is.”

-If you had actually taken such a trade, you would have gained $30 because the price went up to $4 per Bitcoin and Johnny said he agreed to sell you 10 Bitcoin for the same going rate as 1 Bitcoin contract amount. [10*$4=$40. You started with $10; that’s +$30]

It’s important to not get confused with the word ‘contract’ in this example.

Contract = Bitcoin in our example.

And every Bitcoin = $1 at the time that you and Johnny make your deal.

Just to be clear.

Now, Let’s Reverse Back to You Meeting Johnny Again:

-You only have $1 in your pocket.

-Johnny is willing to allow you to buy Bitcoin for $1 in seven days no matter what happens to the price on the condition that you agree to buy one Bitcoin [contract] for $1 in seven days.

-However, since you’re so confident that the price will go up in seven days, you’re thinking about using ‘leverage’.

-As a broker I hold your dollar and allow you to trade 10x your limit, which = $10 [10 contracts].

Now There’s an Obvious Potential Issue That Can Arise Here

-You only have $1.

-Let’s say seven days from now the price actually is down to $.50. Now the 10 contracts are only worth $5.

-That doesn’t matter though because you agreed that you were going to buy all 10 contracts for $10 no matter what.

-With $1, you are $9 short of what you need and now there’s an issue because a contract was made here.

-This means that I’m probably not getting my money back either because I didn’t front you that 10x leverage for nothing.

So how do we avoid this dilemma?

Via liquidations.

-I’m a smart broker, so I decide to do some mental math in my head.

-I know that, at a 10x leverage, if the price of Bitcoin in this hypothetical examples goes down by anything over $.10, then you won’t be able to pay me back.

At $.90, the price of 10 contracts would be $9.00. If that were the case, you only have to give Johnny that $1 to cover the difference (since you agreed to pay $10 no matter what).

-If you’re having trouble understanding this, remember that futures ‘skip a couple steps’. If this were a literal situation where we were dealing with Bitcoin, you would have had $10 [enough to buy 10 physical Bitcoin] (x10 loan).

-The futures model (in practice and theory) assumes that as a responsible individual, you would take that extra money you got from the broker and use that to buy 10 Bitcoin with your $10, just in case you’re wrong . So they’re assuming a trader would not spend it on cars, clothes, jewelry, alcohol, whatever…

-If the price did go down to $0.90, you would more than likely sell 10 of those Bitcoin and that would give you $9. Plus you already had $1 to start with. So you’d be able to still afford to give Johnny his initial investment back in seven days if the price went down to $0.90 [remember, you agreed to buy those Bitcoin for $10 in seven days no matter what].

Hopefully that made sense ^.

The take away here is that the amount that you start with (whatever you’re leveraging — the actual cash you really have on hand) is what is used to determine which price that you’ll be liquidated at.

In this scenario, if the price hit $0.90 then the trade would be closed automatically and you would lose your $1 entirely. This way, the exchange does not lose off of your reckless trade.

That’s why people say that there is a risk to futures’ trading. Because at x10 leverage, you can lose all of your money that you have on the trade from being -10% in the trade.

If you trade without leverage, the price would need to go to zero (in our example) in order for you to lose all of your money.