Every day, the price fluctuations get a new gains and losses incurred in the futures contracts. Businesses, companies, and people try to avoid the risks resulting from price fluctuations using a strategy called hedging. One of the very common methods to hedge would be to utilize financial instruments called derivatives. Derivatives are types of contracts that permit investors and market stakeholders to base the costs of securities on ones underlying assets. There are lots of several types of derivatives, and one could well be the futures agreement.
How do Futures Contracts Work?
The futures contracts is a kind of financial derivatives that is made between two parties, who accept purchase and sell specific goods in a future time, at a price that is agreed in the present time. The buyer in a futures contracts has the long position, while the seller has got the short position. Futures contracts are one way to mitigate the potential risks of selling price movements. Inside a futures contract, there is usually a margin of 15% to protect both parties from fluctuation risks and an excessive amount of losses.
For example, in the futures contracts, a farmer agrees to market his crops to some 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 holds the short position, loses $10 per sack of rice. The customer, who holds the long position, gains $10 for every sack of rice he buys from the farmer within the futures contracts. But due to the high leverage in futures contracts, the farmer is still protected.
How to Hedge in Futures Contract
When deciding to enter a futures contract, it is important to NOT invest most of ones asset shares within the contract. For example, if one is a farmer, he must only commit to sell at most 40% of his total produce to a futures contract. When the price fluctuates higher than the agreed selling price in the contract, he's still protected through the 60% from the crops that he will sell out of the box within the cash market. If one is really a buyer within the futures contract, he must ASSUME that the prices from the commodities will visit around 10%, so he must prepare to lose 10% within the deal. Whether or not the buyer loses in the futures contract, he's protected from risks while he can still manager their farms from the cash market at affordable prices.
Always think about the probabilities of losses when getting 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.
Author Resource:
To learn more about hedging and other techniques involved with trading futures and what's involved with Futures trading visit ftacademy.com.
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