Managed Futures

Unlike stocks, which represent ownership in a company and can be held for a long period of time, futures contracts have finite lives. These contracts are mainly used for hedging against commodity price fluctuations rather than for the buying or selling of the actual cash commodity. A futures contract is defined as a legally binding agreement, made on the trading floor of the exchange, to buy or sell a commodity or financial instrument sometime in the future. Futures contracts are standardized according to the quantity, quality, and delivery time and location for each commodity. The only variable is price, which is discovered on an exchange floor.

The buyer of the futures contract (the party with the long position) agrees on a fixed purchase price to buy the underlying commodity (corn, wheat, or T-Bills, for example) from the seller at the expiration of the contract. The seller of the futures contract (the party with the short position) agrees to sell the underlying commodity to the buyer at expiration at the fixed sales price. As time passes, the contract's price changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader.

Margin and Leverage

Buyers and sellers of futures contracts must make an initial "good faith" deposit (margin). Margin is money deposited by both the buyer and seller of the contract to assure the integrity of the contract. This margin is a performance pledge, ensuring that obligations made by both parties of the contract will be honored. Minimum margins are set by the exchange and are usually 10% or less of the total value of the futures contract. Your account executive can give you up to date margin requirements.

Futures traders can exercise substantial leverage by utilizing margin to control a futures contract. This leverage allows investors with limited financial resources the possibility to make better than average percentage profit gains when they are correct about the direction of the market, but by the same token, they will incur the same loss if they are wrong. The effective use of stop loss orders can help minimize these losses.

Offsetting Positions

Only a small percentage of futures contracts traded are actually held until delivery. Futures contracts expire on specific dates during the contract month. At any time prior to expiration, the trader may close out their obligation through an opposite or offsetting trade. By offsetting a futures contract, the trader cancels any obligation he has to take delivery of the underlying commodity. For example, if a trader is long one June Live Cattle contract and they want to exit their position they will sell one June Live Cattle contract to offset he position. By exiting this position the trader cancels any obligation they have to take delivery of the underlying commodity.

Example

Tony calls his broker and enters an order to buy (long) one December corn at $3.00. Jon calls his broker and places an order to sell (short) one December corn at $3.00. Both Tony and Jon are required to put up $900.00 margin monies to ensure contract delivery. That day December corn trades at $3.00. Both orders are filled on the exchange floor. Tony has entered into an agreement to buy 5,000 bushels of corn at $3.00 in December. Jon has entered into an agreement to sell 5,000 bushels of corn at $3.00 in December. In November, a month later, December corn is trading at $4.00 per bushel. A Chicago Board of Trade corn contract size is 5,000 bushels. Tony's agreement to buy corn at $3.00 has a profit of $1.00 per bushel or $5,000.00 ($4.00-$3.00 X 5,000 bushels, minus commissions and transaction fees). Jon's agreement to sell corn at $3.00 has a loss of $1.00 per bushel or $5,000.00 ($3.00 - $4.00 X 5,000 bushels plus commissions and transaction fees). To offset their positions and realize their profits and losses, Tony has to sell one December corn contract and Jon has to buy one December corn contract.

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