To Use Hedging In Futures Trading
Every day, the cost fluctuations affect the gains and losses incurred in the futures contracts. Businesses, companies, the ones protect themselves from the potential risks resulting from price fluctuations using a strategy called hedging. One of the very common methods to hedge is to utilize financial instruments called derivatives. Derivatives are kinds of contracts that permit investors and market stakeholders to base the costs of securities on ones underlying assets. There are many several types of derivatives, and one of these is the futures agreement.
How do Futures Contracts Work?
The futures contracts is really a type of financial derivatives that’s made between two parties, who accept purchase and sell specific goods in a future time, with a price that is agreed in the present time. The buyer in a futures contracts has the long position, while the seller has the short position. Futures contracts are one method to mitigate the potential risks of selling price movements. In a futures contract, there is usually a margin of 15% to protect both sides from fluctuation risks and too much losses.
For example, within the futures contracts, a farmer agrees to market his crops to a buyer for $30 per sack of rice one month from now. After one month, the price of rice jumps to $40 per sack. The farmer, who supports the short position, loses $10 per sack of rice. The buyer, who holds the long position, gains $10 for every sack of rice he buys in the farmer within the futures contracts. But because of the high leverage in futures contracts, the farmer is still protected.
How to Hedge in Futures Contract
When choosing to enter into a futures contract, you should NOT invest most of ones asset shares in the contract. For example, if one is a farmer, he must only commit to sell at most 40% of his total produce to some futures contract. If the price fluctuates higher than the agreed selling price within the contract, he’s still protected by the 60% of the crops he will sell out of the box within the cash market. If one is really a buyer in the futures contract, he or she must ASSUME how the prices from the commodities will visit as much as 10%, so he must prepare to get rid of 10% within the deal. Even if the buyer loses within the futures contract, he’s protected from risks because he can continue to buy crops in the cash market at affordable prices.
Always think about the probabilities of losses when entering into derivatives. The wise way is to hedge these futures contracts is to implement prudence and caution in trading commodities and adding a bit of speculation when it comes to price changes.