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A Guide to Understanding Opportunities and Risks in Futures Trading

from The National Futures Association

Basic Trading Strategies

Even if you should decide to participate in futures trading in a way that doesn’t involve having to make day-to-day trading decisions about what and when to buy or sell (such as having a managed account or investing in a commodity pool), it is nonetheless useful to understand the dollars and cents of how futures trading gains and losses are realized. If you intend to trade your own account, such an understanding is essential.

Dozens of different strategies and variations of strategies are employed by futures traders in pursuit of speculative profits. Here are brief descriptions and illustrations of the most basic strategies.

Buying (Going Long) to Profit from an Expected Price Increase

Someone expecting the price of a particular commodity to increase over a given period of time can seek to profit by buying futures contracts. If correct in forecasting the direction and timing of the price change, the futures contract can be sold later for the higher price, thereby yielding a profit. If the price declines rather than increases, the trade will result in a loss. Because of leverage, losses as well as gains may be larger than the initial margin deposit.

For example, assume it’s now January. The July crude oil futures price is presently quoted at $15 a barrel and over the coming month you expect the price to increase. You decide to deposit the required initial margin of $2,000 and buy one July crude oil futures contract. Further assume that by April the July crude oil futures price has risen to $16 a barrel and you decide to take your profit by selling. Since each contract is for 1,000 barrels, your $1 a barrel profit would be $1,000 less transaction costs.

    Price per barrel Value of 1,000 barrel contract
January
Buy 1 July crude oil futures contract
$15.00 $15,000
April
Sell 1 July crude oil futures contract
$16.00 $16,000
 
Gain
$1.00 $1,000

* For simplicity, examples do not take into account commissions and other transaction costs. These costs are important. You should be sure you understand them.

Suppose, instead, that rather than rising to $16 a barrel, the July crude oil price by April has declined to $14 and that, to avoid the possibility of further loss, you elect to sell the contract at that price. On the 1,000 barrel contract your loss would come to $1,000 plus transaction costs.

    Price per barrel Value of 1,000 barrel contract
January Buy 1 July crude oil futures contract $15.00 $15,000
April Sell 1 July crude oil futures contract $14.00 $14,000
  Loss $1.00 $1,000

Note that if at any time the loss on the open position had reduced funds in your margin account to below the maintenance margin level, you would have received a margin call for whatever sum was needed to restore your account to the amount of the initial margin requirement.

Selling (Going Short) to Profit from an Expected Price Decrease

The only way going short to profit from an expected price decrease differs from going long to profit from an expected price increase is the sequence of the trades. Instead of first buying a futures contract, you first sell a futures contract. If, as you expect, the price does decline, a profit can be realized by later purchasing an offsetting futures contract at the lower price. The gain per unit will be the amount by which the purchase price is below the earlier selling price. Margin requirements for selling a futures contract are the same as for buying a futures contract, and daily profits or losses are credited or debited to the account in the same way.

For example, suppose it’s August and between now and year end you expect the overall level of stock prices to decline. The S&P 500 Stock Index is currently at 1200. You deposit an initial margin of $15,000 and sell one December S&P 500 futures contract at 1200. Each one point change in the index results in a $250 per contract profit or loss. A decline of 100 points by November would thus yield a profit, before transaction costs, of $25,000 in roughly three months time. A gain of this magnitude on less than a 10 percent change in the index level is an illustration of leverage working to your advantage.

    S&P 500 Index Value of Contract (Index x $250)
August Sell 1 December S&P 500 futures contract 1,200 $300,000
November Buy 1  December S&P 500 futures contract 1,100 $275,000
  Profit 100 points $25,000

Assume stock prices, as measured by the S&P 500, increase rather than decrease and by the time you decide to liquidate the position in November (by making an offsetting purchase), the index has risen to 1300, the outcome would be as follows:

    S&P 500 Index Value of Contract (Index x $250)
August Sell 1 December S&P 500 futures contract 1,200 $300,000
November Buy 1  December S&P 500 futures contract 1,300 $325,000
  Loss 100 points $25,000

A loss of this magnitude ($25,000, which is far in excess of your $15,000 initial margin deposit) on less than a 10 percent change in the index level is an illustration of leverage working to your disadvantage. It’s the other edge of the sword.

Spreads

While most speculative futures transactions involve a simple purchase of futures contracts to profit from an expected price increase — or an equally simple sale to profit from an expected price decrease — numerous other possible strategies exist. Spreads are one example.

A spread involves buying one futures contract in one month and selling another futures contract in a different month. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.

As an illustration, assume it’s now November, that the March wheat futures price is presently $3.50 a bushel and the May wheat futures price is presently $3.55 a bushel, a difference of 5¢. Your analysis of market conditions indicates that, over the next few months, the price difference between the two contracts should widen to become greater than 5¢. To profit if you are right, you could sell the March futures contract (the lower priced contract) and buy the May futures contract (the higher priced contract).

Assume time and events prove you right and that, by February, the March futures price has risen to $3.60 and the May futures price is $3.75, a difference of 15¢. By liquidating both contracts at this time, you can realize a net gain of 10¢ a bushel. Since each contract is 5,000 bushels, the net gain is $500.

November Sell March wheat @ $3.50 bushel Buy May wheat @ $3.55 bushel Spread 5c
February Buy March wheat @ $3.60 bushel Sell May wheat @ $3.75 bushel Spread 15c
  $.10 loss $.20 gain  

Net gain 10¢ bushel
Gain on 5,000 bushel contract $500

Had the spread (i.e., the price difference) narrowed by 10¢ a bushel rather than widened by 10¢ a bushel, the transactions just illustrated would have resulted in a loss of $500. Virtually unlimited numbers and types of spread possibilities exist, as do many other, even more complex futures trading strategies. These are beyond the scope of an introductory booklet and should be considered only by someone who clearly understands the risk/reward arithmetic involved.

Next chapter: Participating in Futures Trading


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