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Risks in the Futures Market

Within investing or trading the major criteria is the balance between risk and return. For every decision which is made it is important to know if the returns are commensurate with the amount of risk taken. When doing a detailed analysis it does look that investment in other areas have a much lesser degree of risk when compared to the Futures market. However there is a major fallacy in this thought.

Let us look at two other major investment vehicles used generally. When people want to build wealth they would either invest in equities or real estate. Within equities one can invest in index funds like Vanguard, mutual funds following particular sector or strategy or individually invest in stocks. When investing in stocks it might seem that buying blue chip companies is a safe bet giving adequate returns with minimal risk. Microsoft gave close to 0% returns in the last decade even after giving higher profit every year and maintaining their profit margin. Buying treasury funds would have given investors higher returns than Microsoft. Hence there is an inherent risk when doing personal trading in equities.

At the same time in the last decade one of the biggest myths of investment was broken. It was a common belief for decades that the house prices can only go one way- UP. Many investors used their savings to invest in real estate as a backup for their old age. They saw heavy erosion of their equity and many ending in foreclosure. Hence there is inherent risk in every investment (other than treasury notes).


Fig: Risk and Loss are a major component of any investing and more so within Futures trading.

Trading in a Futures market is a bit different. Hedgers are essentially trying to protect themselves and their business against unfavorable movement of price in the future. Even if they end up making non profitable decision their purpose of hedging would have been achieved. For example a farmer who wants to sell wheat in 6 months sells a futures wheat contract maturing in 6 months at $8.50 per bushel. If the market price of wheat is $9.00 per bushel in 6 months he would end up losing $0.50 per bushel or $2500 for the contract of 5000 bushels. However his basic purpose of having a definitive price for his crop is achieved. He can plan accordingly and make sure that the input cost is such that it gives him a net profit after selling wheat at $8.50 per bushel. On one hand there is a loss however the advantage is that it leads to smoother planning of operations and in the long run helps in the sustainable development of business. (However massive hedging can be detrimental too. VeraSun Energy Corporation ended up going bankrupt because it made massive hedging bets for corn which it ended up purchasing at a very high price. By the time of delivery the price of corn had reduced to half thus causing the company to lose millions of dollars.)

On the other end of the spectrum are speculators are trying to gain profit from the movement of price in their favor and in return end up providing liquidity to the market. The speculators do not have any interest in the underlying commodity and any trade would be beneficial if they make a profit from it. However the biggest risk in the futures market is the amount of leverage which can be used to buy contracts. If a wheat contract of $100,000 has to be purchased the initial margin in the account is less than $5,000. This gives a leverage of more than 20:1. A 1% movement in the price of wheat would end up showing as a 20% movement in the account of the trader both favorable and unfavorable. Because of this volatility the mindset while investing in futures market is much different than in other investment vehicles like equity and real estate. One can have a simple buy and hold strategy in equities and real estate but not in futures. A trader needs to be actively monitoring and looking for new information affecting the price of the contract. A series of bad decisions can cause huge losses. Although initial margin requirements are less, as a beginner one should use lower leverage while trading. Instead of keeping $5,000 against $100,000 wheat contract a trader can easily keep $20,000 or more amount in the account. This would buffer the contract against random swings in the market because of some unfavorable news regarding the commodity.

The Commodities Futures Trading Commission (CFTC) requires Futures Brokers to issue detailed risk disclosure documents.  The CFTC has a strict policy where futures brokers "may open a commodity futures account for a retail customer, the customer must receive a written disclosure statement and send back to the Broker a signed and dated acknowledgment that the customer has received and understood the statement. The statement informs the customer of some of the risks inherent in futures trading and asks the customer to consider carefully whether it is in a financial position to take such risks."

Introduction to the Futures Market Tutorial

1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market



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