by Keith Cotterill

Leverage can be your greatest friend, and in the wrong hands your greatest enemy.  One obvious example of leverage is the National Lottery.  You can pay only $1.00 and have the opportunity to win (through pure luck) millions of dollars, turning $1.00 into $15,000.00!  Of course in the lottery your total loss is limited to your original investment.

Unlike shares and options where you have to pay in full for the transaction, futures contracts, as you are probably aware, only require a small deposit to control thousands of dollars worth of a physical commodity.  You only need to put down a deposit of 5-10% of the total value of the underlying commodity to be able to buy or sell a contract.  The advantages of this system are obvious – although you have to only put up a small deposit, if your analysis of the market proves to be correct, you are set to gain from the actual change in the value of the underlying commodity.

In the markets leverage can be a two-edged sword.  As fast as you can make money you can lose it.  This is why futures trading is classed as a high-risk investment.  But risk is only dangerous if you create risk… by lacking the necessary information about the market you are trading in.

So as speculators, just like hedgers, there are two ways in which you can be positioned in the market.  However this time, there is no interest in the underlying commodity, only the price fluctuations of that particular market and how you can exploit them for pure profit.

Make Money from Rising Prices

Every business revolves around the principle of buying at a low price and reselling at a higher price for a profit.  From a corner shop to national supermarket chains, all buy in at a low price and then hope to sell at a higher price for a profit.

Going Long: If you are LONG, it means that you have bought anticipating higher prices.  You are said to be ‘long the market’ if you buy shares, futures, bonds or options.  Just as you would buy an ordinary stock market share in the expectation of prices rising, it’s the same with Futures contracts. 

Let’s take a look at an example.  Silver trades on the Commodity Metal Exchange (COMEX) in New York in contract sizes of 5,000 troy ounces.  If July (delivery) silver is currently trading at $5.00 an ounce, this means one contract of July silver is worth $25,000.

For a small deposit of $1,500 or 6% of the contract value ($25,000) you could buy July silver futures in anticipation of higher prices.  So let’s imagine that over the next month the price of July silver rose to $6.00.  And let’s say that you bought one contract at $1,500.  Your total contract value would have risen to $30,000 ($6.00 x 5,000 troy ounces).

So with your $1,500 deposit (which is by its nature returnable when you exit your trade) you were able to turn a 20% movement in the cash price of silver into an actual gain of 333% on your contract.  Within a matter of months or weeks you could have made $5,000 profit on the underlying commodity, excluding transaction costs. 

But, what if your analysis showed that silver prices were going to fall?

Make Money from Falling Prices

The principle of buying low and selling high is easy to understand, but when you tell someone they can make money from falling prices in the markets as well as rising prices, they inevitably ask “How do you do that?”

Going Short: SHORT is simply a term used in the markets by those who have sold first anticipating lower prices when they come to buy.  You are said to be ‘short the market’ if you sell shares, futures, bonds, or options.  In other words, you are expecting prices to fall.

Let me give you an example of everyday life that will help to clarify how you can sell something without first owning it.  Thumbing through a magazine recently you saw an antique table that you would like to buy.  You decide to go to a local antique shop to see if they have one like it.  You show the owner the table that you are after and then ask if he has one like it for sale.  He says “No, but I know where I can get you one that is just like it”.  He then makes a telephone call and informs you he has located the one you want and that it will cost you $500.  What he doesn’t tell you is that it will only cost him $150 to buy it.

Stop and think about what has just happened.  The owner of the antique shop has sold to you something he/she does not yet own for $500; and will buy this antique table for $150, making an instant profit of $350.  As long as the price he can buy the table for is lower than his selling price, then he stands to make a profit.

Why not use the same leverage in the markets?  For example, you can sell to someone else a DEC gold futures at $389 an ounce.  In order to make a profit you will have to be able to buy Dec gold at a lower price than $389 an ounce (just like the antique dealer did with the table).

So imagine that the price of Dec gold fell to $340 an ounce – a drop of $49.  How much could you have made by going successfully short on the market?  Let’s take a look.  Gold, like silver, also trades on the COMEX exchange in New York, but this time in contract sizes of 100 troy ounces.

Dec gold is currently trading at $389 an ounce.  This means one contract of Dec Gold is worth $38,900.  By going short on gold you have managed to successfully predict a fall in prices.  In this case the price difference is $4,900, which equals your profit.