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One of the most common ways to hedge is to utilize financial instruments called derivatives. Derivatives are types of contracts that allow investors and market stakeholders to base the prices of securities on ones underl..

11 Feb 2011

By Francis Jackson

Every day, the price fluctuations affect the gains and losses incurred in the futures contracts. Businesses, companies, and people protect themselves from the risks posed by price fluctuations by using a strategy called hedging.

One of the most common ways to hedge is to utilize financial instruments called derivatives. Derivatives are types of contracts that allow investors and market stakeholders to base the prices of securities on ones underlying assets. There are many several kinds of derivatives, and one of these is the Futures contracts.

How do Futures Contracts Work?

A Futures Contracts is a type of financial derivatives that is made between two parties, who agree to buy and sell specific goods at a future time, with a price that is agreed in the present time.

The buyer in a futures contracts has the long position, while the seller has the short position. Futures contracts are one way to mitigate the risks of market price movements. In a futures contract, there is usually a margin of 15% to protect both parties from fluctuation risks and too much losses.

For example, in this trading derivative, a farmer agrees to sell his crops to a 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 buyer, who holds the long position, gains $10 for every sack of rice he buys from the farmer in the futures. But because of the high leverage in futures trading, the farmer is still protected.

How to Hedge in Futures Contract

When deciding to enter into a agreement, it is important to not invest majority of ones asset shares within it. For example, if one is a farmer, he must only commit to sell at most 40% of his total produce to a futures trade.

If the price fluctuates higher than the agreed selling price in the contract, he is still protected by the 60% of the crops that he will sell as is in the cash market. If one is a buyer than they must assume that the prices of the commodities will drop by as much as 10%, so he must prepare to lose 10% in the deal. Even if the buyer loses in the futures contract, he is protected from risks because he can still buy crops from the cash market at lower prices.

Always consider the possibilities of losses when entering into any type of financial products. The wise way is to hedge these futures, and be sure toto implement prudence and caution in trading commodities and adding a bit of speculation when it comes to price changes.

Courtesy. EzineArticles.com