If you see risks for what they are, you may be able to contain them.
The futures market was founded on the principle of risk transfer. Investors seeking to minimize their exposure to certain risks transferred those risks to others who were either trying to protect against an opposite risk, or were willing to take the risk in the hope of making a profit.
That’s still the case with futures. But because of the way these products work, there’s also the risk that a transaction may result in a loss that exceeds the amount of your initial margin and potentially cost an almost unlimited amount.
The role of the exchanges
Futures exchanges monitor and act to control price volatility. In most cases, the exchange where a futures contract is traded establishes a daily price limit that prevents the price of that particular contract from rising or falling beyond a preset limit. In this lock limit system, when the high or low price limit is reached, trading is stopped, or locked.
The price limit is set in relation to the closing price on the previous trading day and specifies, in dollars or cents, how far the price can move. For example, if palladium traded at $750 per troy ounce the previous day, the current day’s price limit might be $75. That means no trades could be executed at prices above $825 or below $675. (A troy ounce, the traditional unit of weight for precious metals, is 31.1035 grams.)
Daily price limits are not permanent and exchanges may adjust them. During the delivery month of a futures contract, when the contract expires, price limits are often lifted, sometimes resulting in extreme volatility.
From an investor’s perspective, the risk of daily price limits is that you can’t always liquidate your position before lock down. When the market re-opens, the stabilized price may be well above or below what you need to make a profit — or avoid a loss — with an offsetting contract.
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Just as the exchanges try to control volatility through the daily price limit, you may use various order types, as you can on a stock market, to exert some control over the prices you pay to buy or receive when you sell. The most basic ones include:
Limit orders, the most common variety, name the price at which you will buy or sell a contract. In a volatile market, the transaction may never be completed, however, because the market price may move through the limit price too quickly to be acted upon.
Stop-loss orders specify a price at which a broker should sell a particular contract. When the stop price is reached, the order converts to a market order and the broker must execute the trade at the best current price. The downside is that you could end up selling for less than you want.
Your order may be a day order, which means it expires if it has not been filled by the end of the trading day. Good-till-canceled (GTC), or open orders, on the other hand, do not expire until they are filled or cancelled.
One risk management technique that futures traders use to try to limit their potential losses is to simultaneously buy and sell futures contracts on the same or related underlying commodities at the same time. That’s known as a spread and each side of the spread is known as a leg.
Since realizing a profit depends on making more money on one leg than you lose on the other, what you want is a spread where the price difference widens after you open the positions. In the example illustrated below, you buy single stock futures contracts on A and sell them on B. When the price difference between them increases from $15 to $18, you make money when you offset your opening positions. But when the difference narrows from $15 to $10, you lose money.
* This hypothetical example doesn’t include commissions and other transaction costs, which apply whether you have gains or losses.
Futures Volatility And Risk Transfer Explained by Inna Rosputnia
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