WHAT ARE FUTURES?
A futures contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price.
The vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a contract that was previously purchased liquidates a futures position in exactly the same way, for example, that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, the resulting gain or loss is the difference between the buying price and the selling price less transaction costs (commissions and fees).
Futures prices are established through competitive bidding and are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo and a speculator in Ohio have simultaneous access to the latest market-derived price quotations. And, should they choose, they can establish a price level for future delivery—or for speculative purposes—simply by having their broker buy or sell the appropriate contracts.
WHAT IS LEVERAGE?
To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, gains and losses in futures trading are highly leveraged. An understanding of leverage—and of how it can work to your advantage or disadvantage—is crucial to an understanding of futures trading. The leverage of futures trading stems from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. On a particular day, a margin deposit of only $1,000 might enable you to buy or sell a futures contract covering $25,000 worth of soybeans. Or for $20,000, you might be able to purchase a futures contract covering common stocks worth $200,000.The smaller the margin in relation to the value of the futures contract, the greater the leverage will be. If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can produce large profits in relation to your initial margin. Conversely, if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin. Leverage is a two-edged sword.
For example, assume that in anticipation of rising stock prices you buy one June S&P 500 E-mini stock index futures contract at a time when the June index is trading at 1400. And assume your initial margin requirement is $2,000. Since the value of the futures contract is 50 times the index, each one point change in the index represents a $50 gain or loss. Thus, an increase in the index from 1400 to 1420 would produce a $1,000 profit (20 x $50) and a decrease from 1400 to 1380 would be a $1,000 loss on your $2,000 margin deposit. That’s a 50 percent gain or loss as the result of less than a 2 percent change in the stock index.
WHAT IS GOING LONG?
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.
WHAT IS GOING SHORT?
Selling (Going Short) to Profit from an Expected Price DecreaseThe 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.
WHAT ARE 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. For example, were you to purchase a crude oil futures contract at $61 a barrel and wished to limit your loss to $1 a barrel, you might place a stop order to sell an offsetting contract if the price should fall to $60 a barrel. If and when the market reaches whatever price you specify, a stop order becomes an order to execute the desired trade. As long as the speculator places a stop loss order, his risk is tremendously reduces.
When we hear a story of another speculator going bankrupt, it is probably due to him not putting in a stop loss order when he decides to take a trade/position. Thus when the market goes against him, he has no safety net to get him out and he refuses to get out of the trade and therefore allowing his losses to get out of control. As a speculator, as long as the risk is predefined prior to taking a trade, there is almost no chance that you can go bust in a single trade.
