One of the most important role of futures contracts is hedging, which is an investment to reduce the risk of adverse price movements in an asset. Long and short hedges are available for customers who would like to buy or sell commodities in the future.
Principle of Hedging
If you own a commodity, or you are going to get a commodity in the future at a fixed price, the movement of its price will generate profit or loss. To protect yourself from the risk, you will have to own positions of the opposite side. So your loss or profit will be covered, no matter how the price changes.
A bitcoin miner estimates that he can get 10BTC by mining after a month, based on his current productivity. If he sells the BTC's mined at current price at that time, he would be able to make a profit. But if the price of BTC falls by then, he would lose money. Therefore, the miner needs a BTC futures contract to stablize his income.
Current price of BTC = USD500 / token
BTC futures contract price = UDS500 / contract
The income that the miner wants to stablize = 10BTC * USD500 = USD5,000
Face value of a BTC futures contract = USD100
The number of contracts the miner needs to short= USD5,000 / USD100 = 50 contracts
If the price of BTC rises to USD600 / token after a month:
The loss generated by the futures contract = [face value of contract / (position closing price - face value of contract) / position opening price] * number of contracts = [100 / (600 - 100) / 500] * 50 = -1.6667 BTC
The number of BTC the miner would be able to sell = 10 - 1.6667 = 8.3333 BTC
Income = current BTC price * number of BTC = 600 * 8.3333 ≈ USD5,000
If the price of BTC falls to USD 400 / token after a month:
The profit generated by the futures contract = [100 / (400-100) / 500] * 50 = 2.5 BTC.
The number of BTC the miner would be able to sell = 10 + 2.5 = 12.5 BTC
Income = 400 * 12.5 BTC = USD5,000