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How to read payoff diagrams for futures contracts

In this video, Dr Hong Bo explains how to read payoff diagrams for futures contracts.
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We have already learned that investors can use the futures market either to hedge or to speculate. Investors can take either a long position or short position in the futures market, either buying or selling something. But what does the payoff structure look like? We can see this by examining the following diagrams. The first shows the payoff diagram for an investor who is in a long position in the futures market. For example, the investor bought 6-month cotton futures at the price of 200.
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The horizontal axis indicates the market price of the futures contract, which changes along with the market condition, whereas the vertical axis represents the payoff The gains and losses can be shown by the upward-sloped line that intersects with the horizontal axis at the price of 200. As we can see, if the market price for the 6-month cotton futures is higher than 200, then the investor has made some profit. This is because the investor who bought the futures contract initially, must take an opposite position to close the contract before or on the expiration date. In this case, the investor will need to sell this 6-month cotton futures in order to close the contract.
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So, if the market price is higher than 200, say 250, then the investor bought at a lower price of 200, but sells at a higher price of 250. Hence, the investor made a profit of 50 per unit. On the other hand, if the market price for the futures contract is lower than 200, then the investor will need to sell at a lower the price than the price he initially bought at, so he will make some losses. If you are able to read the payoff diagram for a long futures contract, then you can follow the same logic to read the payoff diagram for a short futures contract.
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Remember that if the investor is in a short position, that is he sold a futures contract initially, then he needs to buy the futures contract later to close the contract. Hence, only when the market the price of the futures contract is lower than 200 can the investor buy at a lower price than the price he initially sold at, making some profit.

We have already learnt that investors can use the futures market either to hedge or to speculate. But what does the payoff structure look like?

In this video, Dr Hong Bo explains how an investor’s position in the futures market – either buying or selling – affects the payoff, or profit and loss.

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Risk Management in the Global Economy

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