Futures Basics

Lets face it, future contracts are extremely risky. One bad trade could wipe your account clean. Like options, futures have great leverage. In the futures market, there are two participants, hedgers and speculators. Hedgers are actually interested in the commodity being traded and want to lock in a price so that they can profit from the changes. A hedger might be a farmer or a coffee company. Speculators just want to profit from the price changes in the commodity. A speculator could be an investor. So what exactly is a futures contract? A futures contract is an agreement between two parties to sell and buy a certain amount of a commodity for a certain price. Both parties are obliged to fulfill their part. Most futures are not held to the expiration date. Wouldn't you be surprised to see 5000 bushels of corn on your yard?

To fully explain futures, I will use an example which is very recent. Actually, this happened today. Sally buys a January Gold contract at a price of $1200. Ok, so what does that mean? The contract is going to expire in January, meaning that if she held to January she would be required to pay $1200 to buy the gold. The $1200 means the dollars per troy ounce of gold. Gold futures are usually in units of 100 troy ounces. So the actual value of the contract is $120,000. Now Sally is not super rich, but can still open this position. She can use leverage to open the position, meaning she only has to put some of the actual amount of the contract. Generally, futures leverage is 1:15 meaning for every $1 you can control $15. So Sally only needs $8000 to open this contract. This $8000 is known as the initial  margin. The maintenance margin could be $5000. Lets look at two scenarios. The price of gold drops down to $1169(which happened today). Now Sally loses $3100 on the contract which means that she only has $4900 in the position. Sally must put more money, actually exactly $3100, to get back to the initial margin level. This is because the amount of money in the position is lower than the maintaince margin. She would get a margin call from a broker, saying that you need to put more money to keep your position. If Sally puts more money in, her position remains open. If not, the broker closes her position. Lets look at scenario 2. The price of gold sky rockets to 1300. Sally's profit would be $10,000 ( Sold contract price- Bought contract price=130000-120000) which is a 125% increase on your initial $8000 on Sally's investment. Sally's account balance would be $18,000. Now what if gold had dropped to $1100. Sally would have lost $10,000, meaning her account would be empty and she would have to pay an additional $2,000.

As you can see, futures are extremely risky and should only be traded when the investor knows the possible risks and losses involved.

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