A critical decision process when dealing in commodity futures contracts is knowing when to go short and when to go long. In the live futures markets, a trader has two basic choices: buy or sell. When you buy a futures contract, you are “going long” on the market in the hopes that prices will rise. For most people, this is the traditional, intuitive mode of capital investment.
But what does it mean to short a futures contract? Read on to learn more about buying and selling commodity futures contracts—and find out how to determine your best course of action when developing your commodity futures trading strategy.
Futures contracts are used by market speculators to gain an advantage by predicting a change in the underlying asset’s price. Speculating on futures is an advanced trading strategy. The large amount of leverage employed means even small moves in commodity prices can lead to exceptional gains or devastating losses.
A commodity futures contract is an obligation to buy or sell a certain quantity of a physical commodity at a predetermined price on a specified date in the future. This type of contract covers various commodities (e.g., energy, currencies, livestock.)
Futures are often contrasted with options contracts, which are similar to futures contracts but require no obligation. As the name suggests, options contracts offer the investor a choice on whether or not to execute the contract. Options, however, are often considered more limited as profits and losses are both capped, unlike in a commodity futures contract.
The CFTC is the official governing body of the commodity futures and options markets. It is a federally mandated U.S. agency with the objective to regulate the futures markets and protect its participants from fraud and manipulation.
Here’s a brief look at the definitions and pledges behind buying and selling:
When you buy a commodity futures contract, you’re making a commitment to assume possession of an underlying asset on a forthcoming date in time. For instance, if you purchase one lot of West Texas Intermediate (WTI) crude oil, you’re pledging to take delivery on 1,000 barrels of oil at contract expiry. If prices rise above your entry point, you’re in a position to profit, but if they fall, the result is a loss.
When selling commodity futures contracts, you are pledging to produce a given quantity of the underlying asset at contract expiry. To illustrate, assume that you sold one lot of WTI crude oil. That means you’re on the hook for producing 1,000 barrels of WTI at contract settlement. Should prices fall beneath your contract purchase price, you are positioned to profit, but if they rise, you’re responsible for the loss.
A long position in a futures contract, or “going long,” suggests the trader will profit if the futures commodity increases in value because they own the investment in question.
|
Pros of Long Position |
Cons of Long Position |
|
Limited losses and a locked-in price |
Susceptible to sudden price changes and short-term moves |
|
No ongoing fees |
Potential to lose money should the price fall |
Short selling, or “going short,” suggests a negative position. This means you will profit if the value of the commodity declines. Going short requires borrowing a security and selling it in the hopes of buying it back at a lower price in the future.
|
Pros of Short Position |
Cons of Short Position |
|
Offers a way to earn profit when a commodity declines in value, allowing for more flexibility |
Requires a margin account |
|
Can be leveraged to offset losses in long positions |
Virtually infinite potential for losses if a price continues to rise |
As you can see, the buy/sell dichotomy is wide. On the buy side of the equation, the goal is simple: buy low and sell high. The sell-side is a bit more complex. Let’s look at what it means to short a futures contract and break down a few strategic implications.
From a functional standpoint, traders have several reasons to short a futures contract:
Strategically, there are several reasons for shorting a futures market. Some of the most common ones include:
So what does it mean to short a futures contract? Simply put, shorting a futures contract means agreeing to sell an asset at a set price and date with the assumption that the price will decrease, so you can buy it later at a lower price in order to profit.
One of the great things about futures trading is flexibility. In other products, such as stocks, mutual funds, and ETFs, it is difficult to gain direct short-side market exposure. High margins, maintenance fees, pattern day trader rules, and tracking errors make it a challenge for retail traders to gain direct bearish exposure. This vastly limits traders’ strategic options and reduces their money-making potential.
When actively trading futures, the best trade is always the profitable one. No matter what you do—whether you are buying or selling—approaching the market with discipline and structure is the key to making your trades winners.
One reason that futures markets in general are a rather popular asset class to invest in is their potential to offset potential losses. This approach is known as hedging, which suggests minimizing risk by locking in the price of a commodity today, regardless of whether the asset is bought or sold in its physical form in the future.
Hedging is a method of diversifying your investment portfolio to reduce exposure to price volatility. Essential steps in the hedging process include strategic selection of the right futures contract and accurate hedge ratio calculation.
Long story short (no pun intended), you go long if you think the commodity’s price is likely to rise, and you go short if you speculate the price will fall.
Your best tool for pursuing profitable trades is an in-depth understanding of the inner workings of your selected markets. An informed and intentional trading strategy results from your ability to read the charts, recognize formations, and accurately identify your entry and exit points. Know when there’s action to be taken—and how to take it—by using these 10 strategies for thinking like a technical trader.