As equities take a tumble, more and more individuals look towards commodities as a new investment horizon. Over the past year, we’ve seen nearly every raw material increase in price dramatically. And at one point or another you’ve heard of the potential profits available in the form of futures trading. But what exactly are futures? How do you make money off commodity price movements?
Futures contracts are exactly that – contracts with a future execution (expiration) date. Each contract represents a price, quantity, and date in which a particular commodity will change hands between a buyer and a seller. If you are the seller of the contract, then you wish for the price of the underlying commodity to decrease by expiration. If the price were to decrease, then you would essentially be able to purchase the commodity at a cheaper price than you are already obligated to sell it for, thus profiting from the difference. And the inverse goes for the buyer.
If you aren’t already aware of the amount of leverage a speculator has in the futures market, then let this be a quick “Futures 101” for you. Futures contracts are leveraged anywhere from 5 to 10 times actual value. A contract that may be worth $100,000, could be controlled for $10,000. Much like the purchase of a home, with respect to your down payment. If you purchased a $100,000 home, and put 10% down ($10,000) you would be responsible for either an increase or decrease in price. Obviously, if the price of your home (contract) were to increase to $105,000, you basically profited $5,000 off your $10,000 investment.
The “initial margin requirement” is the amount of capital required to control any said contract. So if we have a futures contract of Gold, which represents 100 ounces. And the price of Gold is $800/oz. The contract is essentially worth $80,000. Rather than purchase $80,000 worth of gold in CASH, you are allowed to control it with a margin requirement of roughly $6,000. Now keep in mind, margin requirements are subject to change at any time by the exchange. The more volatile a market, the higher the margin requirement. So with $6,000, you can control $80,000 worth of gold. If the price of gold were to move from $800/oz to $820/oz, you have a profit of $20/oz multiplied by the 100 ounces represented in the contract. $20/oz x 100 ounces = $2,000. A $2,000 return off a $6,000 investment! WOW!....BUT, keep in mind it’s a two way street. You can also just as easily lose the trade. Not only do you have a high potential for profit or loss. This change in price can occur very quickly. The daily limit for Gold is currently $75/oz, meaning the maximum it could increase/decrease in price is $75/oz. That’s equivalent to a $7,500 move in relation to your $6,000 investment when you trade gold futures. Not bad for a days work if you catch it on the right side.
