How to Understand Speculation

How to Understand Speculation in Futures
and pass the series 3 exam

A big part of the series 3 exam will be testing you on your understanding of how to speculation in futures contracts. . This article, which was produced from material contained in our series 3 textbook, will help you master the material so that you pass the series 3 exam.

Speculation

The motive of a speculator is to realize a profit on a position in a futures contract based on change in the value of the futures contract. A speculator will buy or take a long futures position when they expect the value of the commodity to increase.An investor or speculator who feels that the price of the commodity is likely to decline would establish a short futures position in an effort to profit from the falling commodity price. To determine the profit or loss on a speculative futures position one must look at all of the following:

• The number of units per contract
• The price per unit per contract
• The price at which the contract was opened
• The price at which the position was offset or closed
• The number of contracts

Going back to our crude speculator who went long 5 December crude oil contracts at 89, if the price of crude oil for December delivery increased to 92.20 as a result of the political unrest and the trader closes out the position with an offsetting sale of the 5 crude contracts at 92.20, the profit would be calculated as follows:

Bought 5 December crude oil at 89
     Sold 5 December crude oil at 92.20 Profit of 3.20 per barrel

Each crude oil contract represents 1,000 barrels of oil; as a result the profit per contract is $3,200 ($3.20 per barrel 1,000 barrels). The trader purchased 5 contracts for a total profit of $16,000 ($3,200 per contract 5 contracts), excluding commissions. If the futures commission merchant (FCM) charges the customer a $50 round?turn commission per contract, the net profit would be $3,150 per contract ($3,200 50) and the total net profit would be $15,750 ($3,150 per contract 5 contracts). Alternatively, if the price of crude oil for December delivery fell from 89 to 87.5 as supply remained strong and the trader closes out the position with an offsetting sale of the 5 crude contracts at 87.50, the loss would be calculated as follows:

Bought 5 December crude oil at 89
     Sold 5 December crude oil at 87.50 Loss of 1.50 per barrel

Each crude oil contract represents 1,000 barrels of oil, as a result the loss per contract is $1,500 ($1.50 per barrel 1,000 barrels). The trader pur- chased 5 contracts for a total loss of $7,500 ($1,500 per contract 5 contracts), excluding commissions. When factoring in commissions on a losing trade, the commission costs will increase the investor’s loss. In this case using the same $50 per round?turn contract commission rate, the loss is increased from $1,500 per contract to $1,550 per contract and the total net loss would be $7,750 ($1,550 5 contracts). Going back to our gold speculator who went short 2 October gold con- tracts at 1445, if the price of gold fell to 1436.50 as a result of the stronger dollar and the trader closes out the position with an offsetting purchase of 2 October gold contracts at 1436.50, the profit would be calculated as follows:

Sold 2 October gold 1445
     Bought 2 October gold at 1436.50 Profit $8.5 per troy ounce

Each gold contract represents 100 troy ounces. As a result, the profit per contact is $850 ($8.50 x 100 ounces). The trader sold 2 contracts for a total profit of $1,700, excluding commissions. Using the same $50 per round?turn contract commission rate, the total net profit would be $800 per contract or $1,600 total ($800 per contract 2 contracts). Alternatively, if the price of gold rose to $1457 per ounce due to contin- ued weakness in the dollar and the trader closes out the position with an offsetting purchase of 2 October gold contracts at 1457. The loss would be calculated as follows:

Sold 2 October gold 1445
     Bought 2 October gold at 1457 Loss of $12 per troy ounce

Each gold contract represents 100 troy ounces. As a result the loss per contact is $1,200 ($12 100 ounces). The trader sold 2 contracts for a total loss of $2,400, excluding commissions. Using the same $50 per round?turn contract commission rate, the total loss would be $1,250 per contract or $2,500 total ($1,250 per contract 2 contracts).

Margin

Initial margin is the amount of money that must be deposited to establish a futures position. The amount is set by the board of directors of the exchange on which the contract trades and the amount is the same for both long and short contract positions. The initial margin is effectively a good faith deposit, as most futures positions do not result in making or accepting delivery of the underlying commodity. Unlike a margin account used by customers for the purchase of securities, there is no loan made to the customer who pur- chases commodities. Futures commission merchants do not loan money to their clients who wish to trade futures contracts and as a result there is no debit balance and no interest changed to the customer. The initial margin requirement is based on a percentage of the total contract value and varies from contract to contract. All futures contracts must be purchased and sold in a margin account. Once the initial margin has been deposited by the cus- tomer, the futures commission merchant will monitor the price of the futures contract to ensure that the customer’s margin balance does not fall below the minimum maintenance level. This is known as marking to the market. As the price of the futures contract changes in the market, the margin balance in the customer’s account will change accordingly. A customer who has pur- chased the futures contract will see their margin balance (equity) rise when the price of the contract increases and will see their margin balance fall when the price of the contract declines. Conversely a customer who has established a short position in a futures contract will see their margin balance fall as the price of the futures contract increases and will see their margin balance increase as the price of the contract declines.

Application

If the initial margin requirement for crude oil is $3.74 per barrel or $3,740 per contract ($3.74 1000 barrels), our crude oil trader who purchased 5 December crude oil at 89 had to deposit the initial margin of $3,740 for each of the 5 contracts. The trader’s total required deposit was $18,700. If the price of crude oil for December delivery increased to 92.20 as a result of the political unrest and the trader closes out the position with an offsetting sale of the 5 crude contracts at 92.20, the trader’s margin (equity) would have increased from $18,700 (original margin) to $34,700. The margin in the trader’s account had increased by $16,000, excluding commissions. The trader made $3.20 per barrel on 5,000 barrels of oil (five 1000?barrel contracts). This is a return of 85.5% (A $16,000 return on a $18,700 investment). Alternatively, if the price of crude oil for December delivery fell from 89 to 87.5 as supply remained strong and the trader closes out the position with an offsetting sale of the 5 crude contracts at 87.50, the loss would be calculated as follows:

Bought 5 December crude oil at 89
     Sold 5 December crude oil at 87.50 Loss of 1.50 per barrel

In this case the investor lost $1.50 per barrel or $1,500 per contract ($1.50 1,000 barrels). Since the investor purchased 5 crude oil contracts, the investor lost a total of $7,500 (5 contracts $1,500 per contract). The trader’s margin (equity) would have fallen from $18,700 (original margin) to $11,200. The trader in this case lost 40% (A $7,500 loss on a $18,700 investment). Let’s go back to our gold speculator who went short 2 October gold con- tracts. If the initial margin requirement for gold is $79.75 per ounce or $7,975 per contract ($79.75 100 troy ounces), our gold trader who sold 2 October gold contracts at 1,445 had to deposit the initial margin of $7,975 for each of the 2 contracts. The trader’s total required deposit was $15,950. If the price of gold for October delivery fell to 1436.50 as a result of the stronger dollar and the trader closes out the position with an offsetting purchase of 2 October gold contracts at 1436.50, the trader’s margin (equity) would have increased from $15,950 (original margin) to $17,650. The profit is calculated as follows:

Sold 2 October gold 1445
     Bought 2 October gold at 1436.50 Profit $8.5 per troy ounce

Each gold contract represents 100 troy ounces. As a result, the profit per contract is $850 ($8.50 100 ounces). The trader sold 2 contracts for a total profit of $1,700, excluding commissions. The return on the short gold con- tracts would be 10.6% (A $1,700 profit on a $15,950 investment). Alternatively, if the price of gold rose to $1457 per ounce because the dollar remained weak and the trader closes out the position with an offsetting purchase of 2 October gold contracts at 1457, the loss would be calculated as follows:

Sold 2 October gold 1445
Bought 2 October gold at 1457 Loss of $12 per troy ounce

Each gold contract represents 100 troy ounces. As a result, the loss per contract is $1,200 ($12 100 ounces). The trader sold 2 contracts for a total loss of $2,400, excluding commissions. The trader lost 15.04% (A $2,400 loss on a $15,950 investment).