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Risks of Futures Trading
Risks of Futures Trading - Introduction
Futures trading is risky. This is what almost every futures adviser, CTA or experienced trader would tell you when you first consider futures trading. Indeed, there is no lack of examples of people, rich or poor, high profile or not that went bankrupt trading futures. However, such comments still make one wonder, how exactly is futures trading risky? If futures trading is so risky, why are so many people still doing it? What are the risks involved in futures trading? What exactly constitutes risk? How exactly can we manage the risks of futures trading?
This free futures trading tutorial shall explore in depth the various risks of futures trading and how such risks can be managed so that futures trading can be both rewarding and safe.
What are the Risks of Futures Trading?
When talking about the risks of futures trading, traders are usually talking about the risk of losing money trading futures, which is the "risk of loss". Since one can lose money trading anything at all, what makes trading futures so much more risky? Unlike trading stocks or other assets, where all you can lose is your committed capital, trading in futures expose you to unlimited liability beyond what you commit to a futures position and sometimes beyond the amount of money you have in your futures trading account! Yes, you can lose more than the money you committed to your futures account and that is what gave futures trading its notorious reputation over the decades. In fact, futures traders have gone bankrupt and owed money from trading futures within a relatively short period of time.
Risk of loss in futures trading can also come about due to other factors which we will explore in detail below.
Risks of Futures Trading - Unlimited Liability
Perhaps the main cause of risk in futures trading is the fact that trading futures exposes you to unlimited liability. Unlimited liability means that losses can accumulate beyond your committed capital or even the amount of cash in your futures trading account as long as the price of the underlying asset continues to move against your futures position. For instance, if you are long a futures contract, losses will accumulate for as long as the price of the underlying asset keeps moving downwards.
In futures trading, you need only commit capital equal to a small predetermined fraction of the the position value, known as the "Initial Margin" in order to put on a futures position. Any losses made are deducted from the initial margin and then a margin call is issued when initial margin becomes too low and if a loss is big enough to wipe out all of the initial margin deposited and there isn't enough money remaining in the trading account to cover the loss, you would end up owing money to the broker which can bankrupt you if you are unable to pay. This is completely different from options trading (in the case of buying options) where you only lose the amount of money you put towards buying the options hence exposing yourself only to limited liability.
Unlimited liability means that a strict stop loss and risk management policy needs to be in place when trading futures and that kind of sophistication may be lacking in new futures traders, which is one of the factors that makes futures trading risky for most beginners.
Risks of Futures Trading - Leverage
Compounding the problem of unlimited liability is the leverage that futures trading gives you. Depending on the ratio of initial margin, futures trading can give you anything between 5 to 100 times leverage. Leverage is great when prices are moving in your favor, allowing you to make a leveraged return. However, leverage is a double edged sword and cuts both ways. When the price of the underlying asset moves against your favor, you will start making leveraged losses.
Assuming you need only pay $10 in initial margin towards a $100 asset and the price of that asset goes down by $10, you instantly make a 100% loss on your initial margin while the price of the underlying asset has moved down only 10%. Indeed, leverage is one of the risks of futures trading that makes it almost impossible for any futures trader to commit every cent into a single futures position. This is why position sizing is so important in futures trading and which is yet another aspect of sophistication that is lacking in beginners.
Risks of Futures Trading - Daily Settlement
Compounding the problem of leveraged unlimited liability is the fact that profit and losses are settled on a daily basis in futures trading at the end of each trading day. Daily settlement is supposed to be a risk control measure which prevents losses from building up to default levels and helps lower risk on the exchange's end. However, daily settlement is detrimental to futures traders as all losses must be settled at the end of each trading day. This can lead to a situation whereby a futures position which is eventually profitable gets closed out prematurely due to losses on short term whipsaw.
Assuming you are bullish on an asset priced at $100 for an initial margin of $10. The asset turned out bullish as you expected, rallying to $120 but whipsawed down to $90 on the first day of the trade before rising to that level. If you did not have enough capital to fulfill margin call requirements on that first whipsaw day, your futures position could be forcefully liquidated for that loss on the first day even before that asset has the chance to move to $120.
The only way to overcome such a situation is to make sure you have enough cash to back up each futures position in the event of temporary price volatilities and that is again where the art of position sizing comes in.
Risks of Futures Trading - Trading Related Risks
Trading related risks of futures trading has to do with your ability to make the correct futures trading decisions and actions. This means being able to make accurate trend and price analysis as well as prediction, being able to decide on the correct futures strategy to take advantage of that prediction and be able to execute the trades without mistake. Yes, you can make correct predictions and trading decisions and still make executional mistakes such as choosing the wrong order, clicking on the wrong expiration month or setting an advanced order wrongly resulting in unforeseen losses. Another trading related risk is the risk of your futures broker filling your futures order at a price slightly more expensive than you would like. This is known as "Slippage".
In fact, futures trading is so demanding that as long as all the steps of futures trading are not done perfectly everytime, you could make unexpected losses.
Risks of Futures Trading - Market Related Risks
Market related risks that apply to all trading activities apply to futures trading as well. Market related risks consists of three main aspects; Systemic Risk, Secondary Risk and Idiosyncratic Risk.
Systemic Risk, also known as Market Risk, is the risk of the overall market trend moving against you, taking your futures position along with it. This means that no matter which specific futures contract you choose to trade and no matter how stable you think the specific asset and industry is, you still run the risk of the overall market trend moving against you. For instance, if you are long a futures contract, you are exposed to the risk of the overall market turning bearish due to an economic crisis no matter how stable you think the asset and industry is. Systemic risk is one risk that cannot be overcome by diversification and is the market risk that all futures traders will be exposed to unless market neutral futures strategy such as futures arbitrage is used.
Secondary Risk, also known as Industrial Risk, is the risk of the specific industry trend moving against you. If you are trading futures only in a specific industry, such as crude oil, then you are not only exposed to the systemic risk of global economic performance but also risks specific to the oil market. Secondary risk can be overcome through diversification by trading futures in multiple markets such as trading in both financial futures as well as commodity futures.
Idiosyncratic Risk, also known as Company Risk, is the risk of the price of the specific company or asset you are trading in moving against you. This happens when you are trading futures only in one specific commodity or company (in the case of single stock futures). In fact, when you trade only in one specific commodity or company, you are exposed to all three levels of market related risks. You could still make a loss even though the overall market and industry is doing well as long as the specific commodity or company you are trading futures in fails to do well. Like Seconday Risk, idiosyncratic risk can be diversified away by trading in multiple companies or commodities.
Risks of Futures Trading - Policy Risk
Policies regulating futures trading changes all the time and some changes in regulation, such as the "uptick rule" or changes in margin policy, may adversely affect your futures trading. As such, keeping abreast of policy changes through the U.S Commodity Futures Trading Commission is one of the most critical thing futures traders need to do.
Risks of Futures Trading - Currency Risk
If you are trading non-forex futures in a foreign market with a foreign currency, you are also exposed to FOREX risk between the invested currency and your home currency. For instance, if you are trading in Single Stock Futures in the US market from Singapore. You are exposed also to exchange rate risk between US dollars and Singapore Dollars. Currency risk can be strong enough to obliterate profits if the invested currency drops strongly against your home currency.
Risks of Futures Trading - Brokerage Risk
Brokerage risk refers to the risk that the futures broker with whom you opened your futures trading account and deposited your capital, closes down for whatever reason there may be, taking all your money with them. This is also why it is important to open your futures trading account with large, reputable, FDIC protected, futures brokers who may be more expensive but will better ensure the safety of your money.