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 (such as a managed account or 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 is a brief description and illustration of several basic strategies.
Buying (Going Long) to Profit from an Expected Price Increase
Someone expecting the price of a particular commodity or item 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 later be sold 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, the gain or loss may be greater than the initial margin deposit.
For example, assume it's now January, the July soybean futures contract is presently quoted at $6.00 a bushel, and over the coming months you expect the price to increase. You decide to deposit the required initial margin of $1,000 and buy one July soybean futures contract. Further assume that by April the July soybean futures price has risen to $6.40, and you decide to take your profit by selling. Since each contract is for 5,000 bushels, your 40-cent a bushel profit would be 5,000 bushels x 40¢ or $2,000 less transaction costs.
Suppose, however, that rather than rising to $6.40, the July soybean futures price had declined to $5.60 and that, in order to avoid the possibility of further loss, you elect to sell the contract at that price. On 5,000 bushels your 40-cent a bushel loss would thus come to $2,000 plus transaction costs.
Note that the loss in this example exceeded your $1,000 initial deposit. Your broker would then call upon you, as needed, for additional funds to cover the loss. Had you not offset the position and the soybean contract was open in your account, your broker would ask you to deposit more margin funds into your account to cover the projected losses marked to the settlement price.
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 expected, the price declines, 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.
For example, assume that in January your research or other available information indicates a probable decrease in cattle prices over the next several months. In the hope of profiting, you deposit an initial margin of $700 and sell one April live cattle futures contract at a price of, say, 85¢ a pound. Each contract is for 40,000 pounds, meaning each 1¢ a pound change in price will increase or decrease the value of the futures contract by $400. If, by March, the price has declined to 80¢ a pound, an offsetting futures contract can be purchased at 5¢ a pound below the original selling price. On the 40,000 pound contract, that's a gain of 5¢ x 40,000 lbs. or $2,000 less transaction costs.
Assume you were wrong. Instead of decreasing, the April live cattle futures price increases to 90¢ a pound by the time in March when you eventually liquidate your short futures position through an offsetting purchase. The outcome would be as shown above.
In this example, the loss of 5¢ a pound on the future transaction resulted in a total loss of the $2,000 plus transaction costs.
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, at least in its simplest form, involves buying one futures contract and selling another futures contract. 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 CBOT mini Wheat futures price is presently $3.50 a bushel and the May CBOT mini 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 will 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 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 1,000 bushels, the total gain is $100.
Had the spread (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 $100.
Because of the potential of one leg of the spread to hedge against price loss in the other leg and because gains and losses occur only as the result of a change in the price difference - rather than as a result of a change in the overall level of futures prices - spreads are often considered more conservative and less risky than having an outright long or short futures position. In general, this may be the case.
It should be recognized, though, that the loss from a spread can be as great as - or even greater than - that which might be incurred in having an outright futures position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures prices, and it is possible to experience losses on both of the futures contracts involved (that is, on both legs of the spread).
Virtually unlimited numbers and types of spread possibilities exist, as do many other, even more complex futures trading strategies. These, however, are beyond the scope of an introductory booklet and should be considered only by someone who fully understands the risk/reward arithmetic involved.
Stop Orders
A stop order is an order placed with your broker to buy or sell a particular futures contract if and when the price reaches a specified level. Stop orders are often used by futures traders in an effort to limit the amount they might lose if the futures price moves against their position.
