Trading Commodity Futures
Sheryl wants to speculate in a near term increase in the price of gold. She calls her broker and buys two December gold futures contracts at $360. At the time cash gold is trading at $358.50. The difference in price of $1.50 is due to the carry cost or interest that can be earned on the cash saved by the margin. By buying the future in lieu of cash gold, Sheryl can invest the difference at 3 month Libor rates of 1.1% for 139 days (1.1% x 139/365 x $360 = $1.50).
Each futures contract represents 100 ounces of gold, so with her purchase of two contracts she has essentially contracted to buy 200 ounces of gold to be delivered to her by the expiration of the contract. The expiration of gold futures always occurs on the last day of trading of the month, which in this case is December 31. The value of the contracts, and therefore how much notional value in gold she controls, is 200 x $360 = $72,000. Futures afford leverage in that there is only a small amount of margin that needs to be "put up" instead of the entire amount: the margin requirement for gold is $2,000 per contract, so Sheryl only has to send her broker $4,000.
Over the next few months the price of gold rises to $400 per ounce. On November 15 Sheryl gets a call from her broker reminding her that the date of first notice is November 28 and that unless she wants to risk taking delivery of the gold, she must either liquidate or roll the contracts before this date. On or after the date of first notice, the seller (or the buyer) has the right to notify the buyer, through the Commodities Clearing Corporation, that he will be making delivery of the physical gold. At this point if Sheryl is still holding the contracts, she has no choice but to take delivery at expiration. She must at expiration pay her broker the additional $68,000 (the purchase price less the margin) plus any other delivery costs like insurance, transportation, and storage. Almost all futures contracts are liquidated before delivery because speculators have no intention of owning the physical and Sheryl is no exception. She decides to just sell the contracts before the notice date so as to not risk delivery (notice of delivery may or may not happen during this period, but must occur if the futures contract is still held on expiration) at $400. Her profit is $8,000 ((400-360) x 200).
Every futures contract is different and before trading you should know all the details, but the above example illustrates most of the important nuances. Remember because of leverage, profits and losses are a very high percentage of the margin, so it is essential to understand your actual dollar risk and maintain discipline.
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