Investments, tenth edition

 Example  22.3 

Speculating with Oil Futures 

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P A R T   V I

  Options, Futures, and Other Derivatives

 

Why does a speculator buy a futures contract? Why not buy the underlying asset 

directly? One reason lies in transaction costs, which are far smaller in futures markets. 

 

Another important reason is the leverage that futures trading provides. Recall that 

futures contracts require traders to post margin considerably less than the value of the asset 

underlying the contract. Therefore, they allow speculators to achieve much greater lever-

age than is available from direct trading in a commodity.  

 Suppose the initial margin requirement for the oil contract is 10%. At a current 

futures price of $91.86, and contract size of 1,000 barrels, this would require margin 

of .10  3  91.86  3  1,000  5  $9,186. A $2 jump in oil prices represents an increase of 

2.18%, and results in a $2,000 gain on the contract for the long position. This is a 

percentage gain of 21.8% in the $9,186 posted as margin, precisely 10 times the per-

centage increase in the oil price. The 10-to-1 ratio of percentage changes reflects the 

leverage inherent in the futures position, because the contract was established with an 

initial margin of one-tenth the value of the underlying asset. 

 Example  22.4 

Futures and Leverage 

 Hedgers, by contrast, use futures to insulate themselves against price movements. A firm 

planning to sell oil, for example, might anticipate a period of market volatility and wish to 

protect its revenue against price fluctuations. To hedge the total revenue derived from the sale, 

the firm enters a short position in oil futures. As the following example illustrates, this locks in 

its total proceeds (i.e., revenue from the sale of the oil plus proceeds from its futures position).  

 Consider an oil distributor planning to sell 100,000 barrels of oil in February that wishes 

to hedge against a possible decline in oil prices. Because each contract calls for delivery 

of 1,000 barrels, it would sell 100 contracts that mature in February. Any decrease in 

prices would then generate a profit on the contracts that would offset the lower sales 

revenue from the oil. 

 To illustrate, suppose that the only three possible prices for oil in February are $89.86, 

$91.86, and $93.86 per barrel. The revenue from the oil sale will be 100,000 times the 

price per barrel. The profit on each contract sold will be 1,000 times any decline in the 

futures price. At maturity, the convergence property ensures that the final futures price 

will equal the spot price of oil. Therefore, the profit on the 100 contracts sold will equal 

100,000  3  ( F  

  0 

   2   P  

 T 

 ), where  P  

 T 

  is the oil price on the delivery date, and  F  

  0 

  is the original 

futures price, $91.86. 

 Now consider the firm’s overall position. The total revenue in February can be com-

puted as follows: