Total Global Steel understand the challenges facing individuals exploring futures and options and are committed to providing you with the knowledge you need for futures trading. 

These Contracts have a number of key features:

1. The buyer of a futures contract, the "long," agrees to buy a specific amount of a specific commodity on a specific date at a specific price, but not necessarily to take delivery.
2. The seller of a futures contract, the "short," agrees to sell a specific amount, of a specific commodity on a specific date at a specific price, but not necessarily to deliver.
3. Futures contracts can be terminated by an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) excuted at any time prior to the contract's expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than delivery.
4. Futures contracts are marked to market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing accounts;
5. The contracts are traded on exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerized network;

Standardised Futures Contract.

• Underlying Instrument
The commodity, currency, financial instrument or index upon which the contract is based;
• Size
The amount of the underlying item covered by the contract;
• Delivery Cycle
The specified months for which contracts can be traded;
• Expiration Date
The date by which a particular futures trading month ceases to exist and therefore all obligations under it terminate;
• Grade or Quality specification and delivery location
A detailed description of the "par" commodity, security or other item that is being traded and, as permitted by the contract, a specification of items of higher or lower quality or of alternative delivery locations available at a premium or discount;
• Settlement Mechanism
The terms of the physical delivery of the underlying item or of a terminal cash payment. The only non-standard item of a futures contract is the price of an underlying unit, which is determined in the trading arena.

The mechanics of futures trading are straight forward

Both buyers and sellers deposit funds, traditionally called margin but more correctly characterized as a performance bond or good faith deposit--with a brokerage firm. This amount is typically a small percentage, less than 10 percent of the total value of the item underlying the contract.

Payoff Diagram of a Long Futures Position

As indicated in Figure 1, if you buy (go long) a futures contract and the price goes up, you profit by the amount of the price increase times the contract size; if you buy and the price goes down, you lose an amount equal to the price decrease times the contract size.

Payoff Diagram of a Short Futures Position

Figure 2 reflects the profit and loss potential of a short futures position. If you sell (go short) a futures contract and the price goes down, you profit by the amount of the price decrease times the contract size; if you sell and the price goes up, you lose an amount equal to the price increase times the contract size.

How it affects you

If a company knows that it has to sell a particular asset at a particular time in the future, it can hedge by taking a short position, therefore locking in the price of delivery. This is called a short hedge. Similarly, a company that knows that it will need an asset in the future can take a long hedge, thus locking in the price of purchase.

It is very important to note that hedging does not necessarily improve the financial outcome, it just reduces the uncertainty. In practice, hedging is not perfect, the basic risk arises due to a number of reasons, some of which were discussed in the introduction: The asset being hedged might be different that the one underlying the futures contract, i.e. using a 30y T-bill to hedge a 10y T-note;

The hedger might be uncertain about the exact time that the delivery has to take place, i.e. a new oil rig that is expected to start extracting next summer, without knowing exactly when; and The futures contract matures after the delivery date that the hedger has in mind, i.e. the hedger needs to buy steel in January but steel futures expire in March.

Hedging (Transferring Risk)

The production and consumption of many commodities frequently results in sizable financial risk and represents a cost that affects the price of a commodity. While the uncertainty of risk cannot be eliminated, producers, processors, merchandisers and others to shift some risk to speculators who willingly accept such risk because of the opportunity for making a profit, can use futures markets. For over a century, many have used futures contracts as financial risk offsets to the cash market.

Hedging allows a market participant to lock in prices in advance and reduce the possibility of an unanticipated loss. Hedgers give up the chance to benefit from favourable price changes in order to gain safety from unfavourable price changes. Hedging is a technique that is used mostly by producers, processors and merchandisers. The producer uses a hedge to transfer the risk that prices may decline when a sale is made. A merchandiser uses a hedge to transfer the risk that prices may increase before a purchase is made.

The process of hedging involves the concurrent use of both cash and futures markets. Since futures and cash prices tend to move together (or similar to each other), it is possible for a steel producer, for example, to hedge the value of an unsold inventory of steel with a sale of a number of futures contracts whose total value is equivalent to the value of the unsold inventory.

Since the merchant owns the steel inventory, they would incur a loss if the price of steel declined. By selling futures contracts, the merchant obtains price loss protection. This is because if price of steel drops, the cash market loss will be at least partially offset by the gains produced by the futures contracts.

When the merchant sells their inventory at the lower cash market price, they will concurrently remove their hedge by purchasing the futures contracts at the lower price. The profit from their futures contracts should roughly equal their loss in the cash market. Conversely, a fabricator or construction company may plan to sell a quantity of rebar for delivery several months from now. However, the owner does not currently have enough rebar to cover the sale.

The owner could hedge by buying enough futures contracts to cover the forward sale of rebar. The owner now has a price for raw material to which operating and production costs can be added to arrive at a base price for the sale. Quoting a price before buying the steel would make the owner vulnerable to loss of profit due to a price rise, but buying futures contracts in a quantity equivalent to their needs, the owner knows that a rise in the cost of the actual steel will be offset by a rise in futures prices to lessen the impact of loss.

The idea behind establishing equal and opposite positions in the cash and futures markets is that a loss in one market should be offset by a gain in the other market. The purpose of a hedge is not to profit, but to avoid the risk of an adverse price move, which would cause major financial loss. Hedges work because both cash and futures prices tend to move together, but they converge as each delivery month reaches expiration. Even though the difference between the cash and futures prices of silver (or gold, copper, platinum, etc.) may widen or narrow as cash and futures prices fluctuate independently, the risk of an adverse change is generally much less than the risk of going un-hedged.

Because the cash and futures markets do not have a perfect relationship, there is no such thing as a perfect hedge, so there will almost always be some profit or loss. However, an imperfect hedge is a much better alternative than no hedge at all in a potentially volatile market. While a hedge transfers risk, it also denies the opportunity to financially gain from favorable price movements in the cash market. For this reason, options on futures contracts are popular among people who seek price protection, but who do not wish to miss a favorable price movement.

With the payment of a premium, the buyer of an option can acquire the right, but not the obligation, to buy or sell a futures contract at a specified price until the option expires. In this way, the holder of a commodity can protect against a price drop in the value of that commodity with an option, but remain free to gain from an increase in the price of the commodity. Any such increase will be offset by the amount of the premium that was paid for the option.

Other Economic benefits of hedging

The ability to hedge makes it possible for producers, fabricators, processors and marketers to operate on narrower profit margins. For example, if the wheat miller has protected his inventory with a hedge, he can add on his milling margin and offer a firm price to the baker. Because the hedge lessens his chance of significant loss from price change, he can sell to the baker at a lower price. The baker who also hedges, can reduce his risk and lower his price, passing the savings on to the consumers. Another benefit of hedging involves financing. While some bankers do not consider hedgers as a factor in loans, others make it a regular policy to do so. Bankers who lend to commercial borrowers say that hedgers can borrow a greater percentage of the value of their commodity, usually at lower interest rates, than can non-hedgers. The lower cost of financing thus permits higher profit margins for the hedger and lower prices for the end-user.