6) Futures Fundamentals: Strategies
A futures contract tries to predict the value of an index or commodity at some time in the future. Different strategies are used by speculators to make a profit out of rising and declining prices. The most common of these strategies are known as going long, going short, and spreads.
An investor that goes long is one who is trying to profit from an anticipated increase in price in the future. This means that the investor enters a contract by agreeing to buy and receive delivery of the underlying at a pre-determined price.
For example, John puts in an initial margin of $4,000 in June, and buys a futures contract of gold at $330 per ounce, for a total of 1,500 ounces or $495,000, that is set to expire by September. John is going long by buying in June and expects the price of gold to go up by the time the contract expires.
By August, the gold price increases to $333 per ounce. John, decides to sell the contract in order to gain profit. The 1,000 ounce contract would now be $499,500 in worth and John made a profit of $4,500. Because of the high leverage, he made over 100% profit by going long. However, the opposite would be true had the price of gold fallen instead.
On the other hand, a speculator who goes short is looking to make a profit from declining price levels. This speculator enters into a futures contract by agreeing to sell and deliver the underlying at a pre-determined price. The speculator makes a profit by selling high first, then repurchase at a lower price in the future.
We go back to John, as an example, who has strong information that the price of sugar is going to decline over the next six months. If today is July, he could sell the contract now then buy it back later within the next six months when the price has gone down.
John’s initial margin deposit is $2000. He sold a sugar contract at $30 per sack for 1,000 sacks, totaling to $30,000 in value.
The price has gone down by January, as predicted, and is currently at $25 a sack. He buys back the contract which is now valued at $25,000. The profit John made is $5,000 by going short! Again, if the price didn’t go down as anticipated, the investment would have ended in a huge loss instead.
This type of strategy involves taking advantage of the difference in price of two different contracts of the same commodity. This strategy is considered a conservative approach of trading in the futures market. It is safer compared to the trading of futures contracts by going long or short (naked).
The different types of spreads are:
Calendar Spread, which involves the purchase and sale (at the same time) of two futures contract of the same type, having the same price, but different delivery dates.
Intermarket Spread, where an investor with contracts of the same month goes long in one market and short in the other.
Inter-Exchange Spread, as the name suggests, involves creating a position in different futures exchanges.