Often we hear investors saying going long or short position in American Futures trading. What exactly that means? Long position and short position refers to buy and sell respectively. A futures contract has an underlying financial asset to be traded sometime in the future that will eventually be closed, so by entering into a long position is actually buying a futures contract now at a price and close the contract say in three months time by reversing the process through selling it. A short position is just the other way round by selling a futures contract now and buys it at the closing date.
So in essence, 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 is known as going long, going short and spread.
Example 1 –Going Long:
When an investor goes long, that is, enters into a contract by agreeing to buy and receive delivery of the underlying asset at a set price. He or she will profit from an anticipated price increase when the price of an underlying asset is greater in the future.
Let’s say, with an initial margin of $2,000 in June, a speculator, David, buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, David is going long, with the expectations that the price of gold will increase by the time contract expires in September.
Outcome: By August, the price of gold increases by $2 to $352 per ounce and David 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, by going long David made a 100% profit with an initial margin of merely $2,000!
Of course, the futures market will not necessarily move according to expectations. Wrong forecasts and market predictions could happen and the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have suffered a 100% of loss realized. It is also important to bear in mind that throughout that time Joe had the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have to respond to several margin calls to replenish his maintenance margin, resulting in an even bigger loss.
Example 2- Going Short:
Let’s say, David, after intense market research, concluded that the price of crude oil will decline over the next six months due to a discovery of new oil saving processing method. She will enter into a futures contract by agreeing to sell and deliver the oil at a set price- she 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.
Supposedly, Sara sells a contract today, a November contract at the current higher price and intends to buy it back within the next six months after the price has declined. Sara is essentially going shortly to take advantage of a declining market. With an initial margin deposit of $3,000, Sara sold on May crude oil contract( 6 months from November and one contract is equivalent to 1,000 barrels) at $25 a barrel, for a total value of $25,000.
By March, the price of oil indeed declines in line with expectations to $20 per barrel and Sara felt it was time to cash in on her profits. As such she will close the contract by buying back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, the drawback is if her research had not been accurate, her investing 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 Corn.
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 on the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE)