Contract trading is an agreement between a buyer and a broker to trade on price movements of assets without actually owning the assets. This is a type of derivatives - financial instruments that derive their value from the price movement of an underlying asset (stock, currency, commodities, securities, etc.). The derivative instrument can be traded independently of the underlying asset. In other words, you don’t need to own the asset to trade contracts.
Through contract trading, traders are able to turn a profit from an asset’s price movement without the added risk of owning the actual asset. This makes contract trading a useful trading instrument in a volatile market like digital currencies, where traders can benefit from price movements on a daily basis.
Leverage is also a key part of contract trading. Traders are able to leverage (or borrow) on an asset while only putting up a small percentage of the asset’s full price. Many trading platforms allow for leverages anywhere from 1x to 100x.
Contract trading allows traders to hedge against fluctuations in the price of assets. For example, if an investor owns 1 Bitcoin today and the price drops by 5% a week later, the investor loses 5% of the value of the Bitcoin owned. On the other hand, if the investor accurately predicts that the price of Bitcoin will drop by 5%, he would have shorted it and profited from the asset’s price movement (without having to own it).
How contract trading works
Buyers and sellers use contract trading as a way to hedge and minimize risks and protect against volatile future price swings. In every contract, it will involve:
- A buyer
- A seller
- An agreed price
When a buyer agrees to buy a contract from a seller, both parties will agree on a specific price. That price moves either up or down (from the contract purchase price). Depending on the direction of the price movement, a profit will be made from either buyer or seller. For example, if the buyer purchases the contract at $100 and the price moves and closes at $120, then the buyer will make a profit of $20. If, on the other hand, the price closes at $95, then the buyer would have made a loss of $5.
The same also applies to the seller, as the price movement will depend on the price agreed by both the buyer and seller (which may result in a profit for one, and a loss for the other).
With speculators, investors, hedgers, and others buying and selling daily, there is a lively and relatively liquid market for these contracts.
An example of how contract trading works
Alice and Bob discuss the stock price trend of a listed company.
Alice: The stock price of Apple will go up due to its release of the new iPhone.
Bob: I don’t agree. The stock price will even fall because of the design defect of the new iPhone.
Alice: You can’t be more wrong. Let’s bet on it. If the share price of Apple goes up, I will give you as much as it has risen. If its stock price falls, you will give me the same amount as it fell.
Bob: Deal. At the same time, in case anyone repudiates, we should sign a contract in front of Chris and pay him a credit deposit.
Chris: OK, that’s a deal! You can always find me to do the settlement work!
Through this process, a contract was created. Neither Alice or Bob bought real shares of the company. Instead, they only made a contract with each other to determine their respective projections on the profits and losses according to their desired prices. The profit and loss results between the two have no influence on the real market at all because neither of them holds real market shares.
You can watch the explainer video here: https://youtu.be/oYmJPb9D57g