To keep things simple, assume that all prices are continuous and that any size o

Question

To keep things simple, assume that all prices are continuous and that any size order may be filled if an action (trigger) price is hit.

a) Last week you sold a gold futures contract at $390 per ounce. The current price for a gold futures contract is $400 and so you are now losing $10/oz. You do not want to incur a loss of more than $20/oz. What order would you place with your broker now to try to limit your loss to this amount?

b) Last week you sold a gold futures contract at $415 per ounce. The current price per ounce for a gold futures contract is $400 and so you are now ahead by $15/oz. You would like it if the price of gold keeps falling, but you want to try to insure that you close out this trade with a gain of at least $5/oz. What order would you place with your broker now to try to accomplish this?

please explain step by step

Explanation / Answer

a) When we sell a future contract, we gain from the fall in price of the underlying.

For a future sale contract the profit equation is F-S

Where F= Futures Price

S= Spot Price

Now, we want the maximum loss to be limited to $20 which corresponds with a spot price of $410. ( When spot price is $ 410, Profit= 390-410=-20.)

In order to limit the maximum loss to $20, we would enter into a contract to buy gold futures at $410( assuming that future contract is availaible at that price). When we buy futures, we gain from the rise in price of the underlying. The profit equation for buy contract is : Profit= S-F

Thus as the price rises above $410, we will lose on sale contract but also gain on the purchase contract which will nullify and loss will be limited to $20.

Lets take an example:

Suppose the price rises to $ 420

Profit on future sale contract= 390-420=-30

Profit on future purchase contract=420-410(as futures price was assumed to be $410)=10

So net loss= $(-30+10)=-$20

Hence loss remains limited to $20. You can try with other spot prices to find that loss remains limited only to $20.

b) In order to have a profit of atleast $5, we would enter into a contract to buy futures at $410.

Lets see how this works.

Suppose the price is $425 at the expiry of future contract,

Loss on sale contract=415-425=10

Profit on purchase contract = 425-410=15

Net Profit=15-10=$5

Thus, whatever the price be the profit is $5. However, this also limits the maximum profit to $5.

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