Understanding risks for what they are can help in managing and containing them effectively.
The futures market was established on the principle of risk transfer. Investors looking to reduce their exposure to specific risks could transfer these risks to others who either sought to hedge against opposing risks or were willing to take on the risk for potential profit.
This foundational concept remains true in today’s futures market. However, due to the nature of these financial products, there is also the risk that a transaction could result in losses exceeding the initial margin, potentially leading to almost unlimited financial exposure.
The role of the exchanges
Futures exchanges work to manage and control price volatility by implementing daily price limits for contracts. These limits prevent prices from rising or falling beyond a predetermined range. When a contract reaches its daily price limit, trading is halted, or “locked,” to prevent further movement in that direction. This system helps maintain stability in the market and manage extreme price fluctuations.
Price limits are set based on the closing price from the previous trading day and define how much a contract’s price can move within a day. For instance, if palladium closed at $750 per troy ounce yesterday, today’s price limit might be $75. This means trading would be restricted to prices between $675 and $825. (A troy ounce, used for precious metals, equals 31.1035 grams.)
Price limits are adjustable and can be changed by exchanges as needed. During the delivery month of a futures contract, price limits are often removed, potentially leading to significant volatility.
For investors, the risk of daily price limits is that they might not be able to liquidate their position before the market is locked. When trading resumes, the price could be significantly different from what is needed to either make a profit or avoid a loss on an offsetting position.
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Contingent orders
To manage your trading prices in the futures market, you can use various order types similar to those in the stock market:
1. **Limit Orders**: Specify the exact price at which you wish to buy or sell a contract. In a volatile market, your order may not be executed if the market price moves away from your limit too quickly.
2. **Stop-Loss Orders**: Set a price at which a broker should sell a contract to limit your losses. Once the stop price is reached, the order becomes a market order and executes at the best available price, which may be lower than your desired price.
3. **Day Orders**: These expire if not executed by the end of the trading day.
4. **Good-Till-Canceled (GTC) Orders**: Remain active until they are either executed or canceled, regardless of the trading day.
These order types help you manage your trading strategy and limit potential losses or secure desired prices.
Spread trading
Futures traders often use a risk management technique called a spread to limit potential losses. This involves simultaneously buying and selling futures contracts on the same or related commodities, with each side of the spread known as a leg.
The goal is to profit from changes in the price difference between the two legs. You want the price difference to widen after opening your positions. For instance, if you buy single stock futures contracts on A and sell them on B, and the price difference between A and B increases from $15 to $18, you make a profit when you close both positions. Conversely, if the price difference narrows from $15 to $10, you would incur a loss.
* 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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