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Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.
For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September.
By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit!
Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.
Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market.
Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.
By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.
As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called "spreads."
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.
There are many different types of spreads, including:
Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates.
Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies.
Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).
Next: Futures Fundamentals: How To Trade »
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