Derivatives vs Futures
In crypto you have undoubtedly come across the words derivatives and futures. These are terms that are often used interchangeably, with as a result the true meaning and purpose of the term gets lost. In this article we will dive into the subject of futures.
Derivatives are financial instruments that derive their value from what the underlying asset is actually worth. As its name implies, a futures contract is a financial contract between two parties to sell and buy an asset at a se t price in the future. In other words, future contracts allow two parties to agree on the price at which they will exchange an asset in the future. Although the duration of future contracts varies, the settlement dates of each contract are always fixed. In essence, before two parties can enter into a futures contract, they must agree on closing the contract on a predefined settlement date.
How does it work?
The explanation of futures and its purpose are explained best when looking at more traditional instruments. Lets use an example of a company that produces wheat, and makes business by selling the produce to a cereal manufacturer. The price of wheat can fluctuate as its vulnerable to natural events, as a harvest can get ruined by the lack of rainfall or an insect plague, which would increase the price of wheat, which is good for the producer, but bad for the manufacturer On the other hand in great conditions there can be an abundance of wheat, which will allow the cereal manufacturer to buy wheat for a cheaper price, but make the producer less profits.
By using futures both the producer and the manufacturer can anticipate the future price of wheat going up or down in the future. This allows both parties to protect themselves to circumstances beyond their control, and maintain a constant revenue stream, to keep them in business. Both parties can lock in a set price in the future in which they do business, regardless of the actual future market price.
If the price rises in the meantime, then on the settlement date the producer could have gotten more money for their product, whereas if price declines, then the manufacturer could have bought their resource for cheaper.
Regardless of the outcome, this can be useful, as companies can budget and plan ahead of time due to this agreement, making it a great option to hedge against unexpected events.
For cryptocurrencies this is not very applicable, as it is not susceptible to any weather or harvest conditions, and therefore in essence purely speculative. This is one of the reasons why futures can be seen as outdated when brought over to crypto. Nonetheless, there are some great benefits to futures because of the ways they are being designed.
Benefits of futures contracts
Shorting
As people can agree not only on higher prices in the future, but also lower prices, shorting an asset becomes available
High liquidity
Because of the ability to short, the fact that they trade through an exchange on regulated terms and agreements, the derivatives are convenient to buy and sell fast, making it a highly liquid trading instrument
Low default risk
Compared to forwards contracts, futures contracts have a low default risk as the agreements are systematic and regulated.
Low commissions
Compared to other derivatives, commision charges are cheap.
Disadvantages of Futures
Lack of customization
Since futures contracts are standardized that come with standard sized, they cannot be tailormade to transaction requirements.
Minimum Deposit Requirement
There is a minimum deposit requirement to be met prior to obtaining a futures contract. This can offset the benefit gained from low commission charges.
So what is the difference between Derivatives and Futures?
The difference between derivatives and futures is their scope. Derivatives are broader in scope as it involves many techniques while futures contracts are narrow in scope. The objective of both is similar since they attempt to mitigate the risk of a transaction that will take place in the future. Because of their varying scope, it is more logical to state that Futures are a form of derivative, rather than something different entirely.
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Disclaimer:
The information provided above is not financial advice but for educational and entertainment purposes. Please do your own due diligence or consult a financial advisor before investing in any digital assets.
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