Understanding Futures Contracts

...Profiting from Hedging
Price Speculation and Leverage

Here, we'll discuss several aspects of commodity futures contracts including:

- Its' definition
- The Concept of Futures Hedging
- Price speculation on contracts
- The power of futures leverage

The Futures Contract Defined

(The commodity can be a "product" like corn, gold or pork bellies,
or a financial instrument like bonds, FOREX currencies, and indexes).

Futures contracts are always two-sided, having both a buyer and seller - or two opposing positions.

If you're the buyer, the seller takes the opposing position, known as the offset. If you're the seller, the buyer is the opposing position, 'offsetting' your selling of the futures contract.

If that's not quite crystal, think of the nature of a futures contract as in buying a product - say a newly introduced, popular large screen plasma TV - on layaway - a sort of futures 'buy now, pay later' arrangement.

You (the buyer) agree to purchase this plasma TV (the commodity)
from a store (the seller) during the summertime at a specific price today.

YOU then put down a small percentage of the total price (equal to what's called the 'initial margin' in futures trading) today as good faith of your eventual purchase in full of the TV at a later future date, say in fall or at Christmas.

At that time, the store (the seller) promises to deliver that plasma TV
to you in exchange for the balance of the purchase price, agreed to
months earlier.

That's a simple way to think about how a contract works.

What's the value of using them? It has to do with a concept called hedging.

The Futures Contract
...Hedging for Protection

The store (seller) is concerned with potential falling plasma TV prices in the fall due to heavy Holiday promotions and cutthroat competition.

He's happy to "transfer" his risk of potential future falling plasma TV prices later on by locking in good price today (contract) by selling you the TV(commodity) now(hedging his risk of potential lower prices later), for delivery off layaway at year end(end of contract).

And you (the buyer) may have been concerned that the plasma TV may be in short supply later in the year, and may rise in price.

So you 'hedge' your bet against potential rising prices, locking in a good price now against potential rising prices later...guaranteeing you get the TV you'll need/want in the future, eliminating the uncertainty of potential higher prices later on.

Futures Contract Benefits

If the TV prices rose, instead of falling, the store won't have made as much as they could have off your sale, but they still made a profit, and avoided the potential for falling prices.

If the TV prices fell, the store is happy as well, as they were still to the good on your sale, vs. potentially taking a loss on the sale in the future due to competitive price cutting at year end.

And you got the TV you wanted at an acceptable price, avoided paying a potentially higher price and potentially avoided not being able to get the TV at all later on, due to potential short supply.

In general, contracts like this provide a measure of risk transference and price protection to both futures contract buyers and sellers, due to the future uncertainties caused by many variables (in trading these are called fundamentals) which affect commodity prices.

Futures Contract Speculation

From our individual perspective, we're only interested in trading futures contracts to (hopefully) profit from on rising or falling commodity prices - - - price speculation.

Profit is achieved either by "going long" a contract(s) (buying low and selling higher), or "going short" ("borrowing" and selling high and buying back lower).

As we're only interested in speculating and making a profit - not taking delivery of the physical commodity - we'll exit, liquidate or offset our position in a trade before the commodity futures contract delivery date
(~ end of the futures contract...by selling to another buyer (if we're long), or buying back from a seller(if we're short).

Depending on our trade position at that point, we'll either have a profit
(if the price moves in our favor), a loss (if the price moves against our position), or possibly break even on the trade, less any broker commissions deducted.

Futures Contract Leverage
...The Good, The Bad and The Ugly

The potential for large profits is made possible due to the inherent leverage in a futures contract.

How does futures trading leverage work?

Let's look at Corn, part of the "Grains" Commodity family.

The size of a Corn contract is 5,000 bushels
(price per bushel is in the $3.50/ea. range in '07).

The price of Corn moves in 1/4 cent increments
(each 1/4 cent move = $12.50).
So a 1 penny move = $50...profit, or loss to you, less broker commissions on the trade.

Follow?

To buy, own and physically take delivery of a corn contract would cost you over $15,000 in late '07.

But, hold on there Charlie...here's the beauty of speculating in futures.

You can 'buy' or more precisely, control and get into the market with one Corn contract for a fraction of that amount....currently, $405.00 per contract (plus maintenance margin).

So, for a relatively very small amount of cash, you have huge leverage, controlling 5,000 bushels of corn worth over $15,000.

And, when it comes to price action,and speculating on it.... that is where the power of leverage really kicks in....or kills you.

(As we noted above, Corn prices move in 1/4 cent increments (each 1/4 cent move = $12.50). So a 1 cent move = $50).

Keeping that in mind, a 10 cent move in corn price = $500.
A 50 cent move in corn price = $2500.

Those figures represent potential profit (or loss)...per contract...on a 10 cent and 50 cent move in the price of corn.

If you're trading multiple commodity futures contracts, simply multiply the number of contracts by the profit/loss potential.

Scales up fast, and makes your eyes glaze over, doesn't it?

With the price of corn jumping up a dollar or more since the end of 2006, if you'd been long 5 corn contracts since last year, you'd be sitting on $15000 to $25000 of profit.

Think about this for a bit.

A 1 cent move in the price of corn is potentially worth $50 to you. THAT'S LEVERAGE. Big ROI for your money.

That's what lures folks into commodity trading. And it also lulls them to sleep with the siren song of riches. Greed kicks in. Excitement takes over. Futures traders forget sound trading and money management practices.

Then the market moves against them. Profits turn to losses.

"KA-CHING!", KA-CHING!" can turn into an empty thud or tinny soup can sound in your trading account, so fast it'll make your head spin.

Burn this clearly into your mind -

FUTURES PRICE MOVES CAN AND WILL MOVE AGAINST YOUR TRADE POSITION(S).

As sure as a 10 cent move in Corn can put $2500 into your pocket...NEGATIVE LEVERAGE...price moving against your position...WILL GRAB IT OUT OF YOUR HANDS EVEN FASTER.

That's the power...AND DANGER...of futures contract leverage.

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