If you are bearish on cocoa, you can profit from a fall in cocoa price by taking up a short position in the cocoa futures market. You can do so by selling (shorting) one or more cocoa futures contracts at a futures exchange.
You decide to go short one near-month Euronext Cocoa Futures contract at the price of GBP 1,812/ton. Since each Cocoa futures contract represents 10 tonnes of cocoa, the value of the contract is GBP 18,120. To enter the short futures position, you have to put up an initial margin of GBP 1,350.
A week later, the price of cocoa falls and correspondingly, the price of Euronext Cocoa futures drops to GBP 1,631 per tonne. Each contract is now worth only GBP 16,308. So by closing out your futures position now, you can exit your short position in Cocoa Futures with a profit of GBP 1,812.
|Short Cocoa Futures Strategy: Sell HIGH, Buy LOW|
|SELL 10 tonnes of cocoa at GBP 1,812/ton||GBP 18,120|
|BUY 10 tonnes of cocoa at GBP 1,631/ton||GBP 16,308|
|Investment (Initial Margin)||GBP 1,350|
|Return on Investment||134%|
In the examples shown above, although cocoa prices have moved by only 10%, the ROI generated is 0%. This leverage is made possible by the relatively low margin (approximately 7%) required to control a large amount of cocoa represented by each contract.
Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.
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