Kenanga Deutsche Futures : Futures 101 (Series 4)

Series 4

Strategies

  • Essentially, 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 are known as going long, going short and spreads.
  1. Going long is when an investor enters a futures contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. For example, let's say that, with an initial margin of RM 4,000 in June, Ali the speculator buys one September FKLI contract. By buying in June, Ali is going long, with the expectation that the price of FBMKLCI index will rise by the time the contract expires in September. By August, the FBMKLCI index value increases by 80 to 1,680 and Ali decides to sell the contract in order to realise a profit. The FKLI contract would now be worth RM 84,000 and the profit would be RM 4,000. Given the very high leverage (remember the initial margin was RM 4,000), by going long, Ali made a 100% profit!

Of course, the opposite would be true if the FKLI value had fallen by 80 points. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Ali held the contract; the margin may have dropped below the initial margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.

  1. Going short is when a speculator enters into a futures contract by agreeing to sell and deliver the underlying at a set price - 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 for the speculator.

Let's say that Sarah did some research and came to the conclusion that the price of crude palm oil was going to decline over the next six months. She could sell a contract today, in February, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market. It is also best to note that the futures market is the only legitimate market in Malaysia to go short.

Suppose that, with an initial margin deposit of RM 6,000, Sarah sold one February crude palm oil (FCPO) contract (one contract is equivalent to 25 tonnes) at RM 2,500 per tonne, for a total value of RM 62,500. By October, the price of crude palm oil had reached RM 2,300 per tonne and Sarah felt it was time to cash in on her profits. As such, she bought back the contract which is now valued at RM 57,500. By going short, Sarah made a profit of RM 5,000. But then again, if Sarah's research had not been thorough, and she had made a different decision, her 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".

  1. 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.
      • 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 in the Bursa Malaysia Derivatives and Singapore Exchange.