If you are bearish on cotton, you can profit from a fall in cotton price by taking up a short position in the cotton futures market. You can do so by selling (shorting) one or more cotton futures contracts at a futures exchange.
You decide to go short one near-month NYMEX Cotton Futures contract at the price of USD 0.4600/lb. Since each Cotton futures contract represents 50000 pounds of cotton, the value of the contract is USD 23,000. To enter the short futures position, you have to put up an initial margin of USD 3,375.
A week later, the price of cotton falls and correspondingly, the price of NYMEX Cotton futures drops to USD 0.4140 per pound. Each contract is now worth only USD 20,700. So by closing out your futures position now, you can exit your short position in Cotton Futures with a profit of USD 2,300.
|Short Cotton Futures Strategy: Sell HIGH, Buy LOW|
|SELL 50000 pounds of cotton at USD 0.4600/lb||USD 23,000|
|BUY 50000 pounds of cotton at USD 0.4140/lb||USD 20,700|
|Investment (Initial Margin)||USD 3,375|
|Return on Investment||68.1481%|
In the examples shown above, although cotton prices have moved by only 10%, the ROI generated is 0.0000%. This leverage is made possible by the relatively low margin (approximately 14.6739%) required to control a large amount of cotton 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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