when settling a futures contract the method depends on the asset physical delivery is standard for commodities like oil gold or wheat however for futures contracts based on stocks and stock indexes the settlement method is cash 1
speculationa futures contract allows a trader to speculate on a commodity s price if a trader buys a futures contract and the price rises above the original contract price at expiration there is a profit however the trader could also lose if the commodity s price was lower than the purchase price specified in the futures contract before expiration the futures contract the long position can be sold at the current price closing the long position investors can also take a short speculative position if they predict the price will fall if the price declines the trader will take an offsetting position to close the contract the net difference would be settled at the expiration of the contract an investor gains if the underlying asset s price is below the contract price and loses if the current price is above the contract price suppose a trader chooses a futures contract on the s p 500 the index is 5 000 points and the futures contract is for delivery in three months each contract is 50 times the index level so one is worth 250k 5 000 points 50 without leverage traders would need 250k in futures trading traders only need to post a margin a fraction of the contract s total value 7 if the initial margin is 10 of the contract s value the trader deposits only 25 000 10 of 250 000 to enter the futures contract if the index falls by 10 to 4 500 points the value of the futures contract decreases to 225 000 4500 points x 50 traders face a loss of 25 000 which equals a 100 loss on the initial margin hedgingfutures trading can hedge the price moves of the underlying assets 2 the goal is to prevent losses from potentially unfavorable price changes rather than to speculate suppose a mutual fund manager oversees a portfolio valued at 100 million that tracks the s p 500 concerned about potential short term market volatility the fund manager hedges the portfolio against a possible market downturn using s p 500 futures contracts assume the s p 500 is at 5 000 points and each s p 500 futures contract is based on the index times a multiplier say 250 per index point since the portfolio mirrors the s p 500 assume a hedge ratio of one to one the value hedged by one futures contract would be 5 000 points 250 1 250 000 to hedge a 100 million portfolio the number of futures contracts needed is found by dividing the portfolio s value by the value hedged per contract 100 000 000 1 250 000 about 80 thus selling 80 futures contracts should effectively hedge the portfolio with two possible outcomes pros and cons of futures tradingfutures trading comes with advantages and disadvantages futures trading usually involves leverage and the broker requires an initial margin a small part of the contract value the amount depends on the contract size the creditworthiness of the investor and the broker s terms and conditions futures contracts can be an essential tool for hedging against price volatility companies can plan their budgets and protect potential profits against adverse price changes futures contracts also have drawbacks investors risk losing more than the initial margin amount because of the leverage used in futures potential speculation gainsuseful hedging featuresfavorable to tradehigher risk because of leveragemissing out on price moves when hedgingmargin as a double edged swordthe futures markets are regulated by the commodity futures trading commission cftc the cftc is a federal agency created by congress in 1974 to ensure the integrity of futures market prices including preventing abusive trading practices fraud and regulating brokerage firms engaged in futures trading 8