Future Trading

Futures traders may decide to take up a short position for a variety of reasons. They may just be seeking to offload contracts they've already profited from, or they may see fundamentals in play that are likely to result in a drop in the price of the underlying commodity being traded via the futures contracts. Futures traders seeking to make money off of taking a short position is by selling contracts via a futures exchange such as the CME Group.

When futures traders decide to take a short position, the traders borrow a contract from a third party and sell it at the current market price in the hope of gaining a profit in the future when they are required to return the contract they borrowed from the third party by then buying the contract again at a price lower than their selling price.

How you can adopt a short position

If you want to adopt a short position on a futures contract, you'll need to get a broker or a third party to lend you a futures contract. Once you've got the contract you sell it at its current price. Later, you must return an identical contract to the third party from whom you borrowed the contract. When a speculative futures trader shorts a futures contract, he or she only makes money if the price of the contract dips by the expiration date of the agreement with the third party.

Basically, when you take a short position, you are essentially making a bet with the person who lends you the futures contract that the contract is going to decrease in price. You win if it does, the other person wins if the contract being borrowed is worth more when you have to return it.

The short futures position offers unlimited profit, but also unlimited risk and attracts two types of futures traders: speculators who are seeking to profit from a dip in the price of the underlying commodity and producers who want to lock in a price of a commodity that the producer intends to sell in the future. The producer's short position is called a short hedge, which essentially is taking up a short position in the futures market while also owning the underlying commodity that's the deliverable of the futures contract. If the commodity's price falls, the traders gain in the value of his short futures position will offset the loss he'll sustain from selling the now less valuable underlying commodity.

An example a short futures position

A futures trader decides to adopt a short position on a wheat futures contract. He borrow a contract that has a value of $5 per bushel and then sells it at that price. The contract accounts for 1,000 bushels of wheat. The value of the contract is therefore $5,000. To adopt this position, the trader will need to deposit an initial margin of about $1,450.

Over the period of the contract, wheat drops precipitously and hits $4.50 per bushel. This makes the value of the contract about $4,500. The futures trader then buys a new futures contract at the lower price and returns it to the person or organization he borrowed the original contract from. The trader has made a profit of $500, the difference between the prices.

However, had the price of the underlying commodity, in this case, wheat, increased, the investor would have incurred a loss. If the trader had had substantial futures contracts and the price had risen significantly, he may have been subject to a margin call, which can be quite financially painful.

Shorting and margin

Futures trading is growing increasingly popular among investors because of increasing availability thanks to electronic trading and because many futures can be traded on margin with a small initial margin requirement. Trading on margin requires the investor to put up only a percentage of the cash value of the instrument, in this case, futures that he is trading. The rest is paid for from borrowed money. This borrowed money is loaned based on other securities being available as collateral. Trading on margin allows futures traders to trade large amounts with little capital outlay on their part.

Trading on margin can turn sour, however, if the market goes against the investor. If trading losses result in a futures trader's margin account balance dipping under the required maintenance level, the trader's broker will issue a margin call, which will require the futures trader to top up his trading account in order to keep his futures position open.