Futures trading involves contracts for the purchase or sale of an underlying asset at a certain price called the exercise price, on a future date known as the expiry date. In trading futures, the opportunity for profit exists, but it also exposes buyers and sellers to some risks.
Although settlement risk is reduced with the presence of the clearing corporation, there are many other factors that traders need to be aware of. Below, we shall discuss the major exposures to risk in futures trading and precisely how such exposure can be minimised.
The Risks of Trading Futures
Any conversation about the risks of trading futures needs to start with the realisation that price risk is not the only risk involved. The following are the main risks every futures trader faces:
1. Price Risk
The most common and simplest risk associated with trading futures is price risk. If you buy futures anticipating a price rise but the price falls instead, you shall incur losses.
For example, if you buy a future in gold at ₹50,000 per 10 grams, expecting the price to rise and it fall down to ₹48,000, you have lost ₹2,000 per 10 grams. Probably the greatest risk involved with trading in futures is adverse price movement.
2. Volatility Risk
Volatility risk is usually under-recognised. Futures markets can be very volatile, and large changes in prices may occur within a very short time. To cut losses, traders usually place stop-loss orders. In times of extreme volatility, the prices may hit stop-loss orders and then move in the desired direction, thus leaving the trader at risk of missing out on the profit.
For example, if you put a stop-loss on ₹49,000 when you buy the gold futures contract, the sudden movement of its price to ₹49,000 might trigger your stop-loss and then later recover to ₹52,000.
3. Risk of Leverage
One of the more important features of futures trading is also one of its biggest risks: leverage. Leverage is what allows traders to control large positions with a relatively small amount of capital. For example, if the margin rises to 10%, it means you are in control of a position of ₹500,000 – just by depositing ₹50,000.
On the reverse side, that also means that losses can be tenfold. A drop of 10% in the price of the underlying asset, while you are maintaining a losing market position against you, can wipe out your entire investment and hence result in huge losses.
4. Interest Rate Risk
Changes in interest rates may impact futures trading on many levels. A futures price is the inbuilt interest, and hence a rise in interest rates may further increase this gap between the futures and spot prices.
For instance, if interest rates go up, then it would certainly mean an increased cost to hold onto futures, which would drift the futures price of Bank Nifty far away from its prices at the spot market. Traders shorting on futures would be much at a loss with this kind of spread widening.
5. Liquidity Risk
Liquidity risk occurs when the inability to buy or sell futures contracts arises from a lack of market participants. In the context of leveraged positions specifically, this becomes very concerning. If you are in a situation where you need to sell a futures contract but can’t find a buyer, then you could end up selling at a hugely discounted price and take substantial losses.
On the other hand, when you still want to sell back the futures contract, but there are no buyers, it is possible that you may have to sell at a much lower price.
6. Spread Risk
Spread risk is similar to liquidity risk. It occurs when buyers and sellers are available but quote prices that are far from the market price and hence result in unattractive terms of trade. For instance, you might find the bid-ask spread stretched in mid-cap futures; hence, you will be forced to buy at higher prices or sell lower than your target price.
7. Execution Risk
Execution risk is simply the risk of making mistakes during trading. Some of the errors are unique to that trader, while others may be across the market. Examples of typical execution errors include executing a buy instead of a sell, mistakenly choosing the wrong contract, or choosing the wrong expiry date. Market-wide execution risks include cases like “fat-finger” mistakes where a large trader or broker makes an error, which affects prices across the market. Such examples of these cases can lead to significant disruptions and affect all those participating in the market.
8. Mark-to-Market Risk
In futures trading, there is a requirement for the daily settlement of profits and losses through a process called MTM. This means you will have to pay notional losses on a daily basis. If you do not have adequate funds to pay for such losses, you may be forced to close out the position at adverse prices and thus suffer actual losses.
9. Settlement Risk
Although the settlement risk associated with exchange settlement is reduced through the practice of settlement through a clearing corporation, there are still settlement risks associated with broker default.
For example, on the verge of a broker’s default, a costly and time-consuming lawsuit can cause a lock-in of funds for the traders who have open positions in the futures market. This is a low-probability risk that has huge financial consequences in case it does materialise.
Futures trading offers significant profit potential, but it also comes with substantial risks. Understanding and managing these risks is crucial for successful trading.
By implementing effective risk management strategies and staying informed about market conditions, traders can navigate the complexities of futures trading and enhance their chances of achieving favourable outcomes. Always remember that careful planning and disciplined trading practices are key to mitigating the inherent risks of futures trading.
