Risk and Return Characteristics of Futures Contracts
October 26th, 2010
When an investor takes a position in the market by buying a futures contract, the investor is said to be in a long position or to be long futures. If, instead, the investor’s opening position is the sale of a futures contract, the investor is said to be in a short position or short futures. The buyer of a futures contract will realize a profit if the futures price increases; the seller of a futures contract will realize a profit if the futures price decreases; if the futures price decreases, the buyer of the futures contract realizes a loss while the seller of a futures contract realizes a profit. Notice that the risk-return is symmetrical for a favorable and adverse price movement.
When a position is taken in a futures contract, the party need not put up the entire amount of the investment. Instead, only initial margin must be put up. Thus a futures contract, as with other derivatives, allows a market participant to create leverage. While the degree of leverage available in the futures market varies from contract to contract, the leverage attainable is considerably greater than in the cash market by buying on margin. While at first the leverage available in the futures market may suggest that the market benefits only those who want to only speculate on price movements. This is not true. Futures markets can be used to reduce price risk. Without the leverage possible in futures transactions, the cost of reducing price risk using futures would be too high for many market participants.
Filed under: Futures Contracts