A future is a contract to buy or sell an underlying asset at a future price, called the exercise price, at a future date, called the expiry date. A futures contract carries equal risk for the buyer and the seller. Let us turn to future contract risk factors. Remember future contract risk is still there, although the settlement risk is taken away by the clearing corporation. Here let us look at some of the major risks in futures trading. How this risk in futures trading can be addressed?
The risks of futures trading
We are referring to the risks as a futures trader. You will be surprised to know that the actual risks of futures trading go much beyond the price risk. Here is how.
- One of the simplest and commonest risks of futures trading is the price risk. For example, if you buy futures, you expect the price to go up. However, if the price goes down, you are at risk of loss. For futures traders, the biggest risks of futures trading come from the adverse movement of prices.
- Volatility risk is often not appreciated as one of the key risks of futures trading. When you trade futures, you normally set a stop loss. However, when markets are too volatile the risks of futures trading get accentuated as the price can trigger the stop loss and then move in your desired direction. This is common on volatile days.
- One of the risks of futures trading that you can never ignore as a trader is the leverage risk. Let us spend a moment on this point. Remember that leverage is an inherent feature of futures trading. When you put a margin of X and trade for 5X, that is leverage and also becomes one of the biggest risks of futures trading if you are not cautious enough. Leverage multiplies your risk just as it multiplies your return. For example, if the initial margin is 10%, it implied 10 times leverage. In other words, a trader can take a position equivalent to Rs.500,000 by merely depositing Rs.50,000. But, this also implies that your losses in a worst-case scenario can get multiplied by 10 times. This is one of the most critical risks of futures trading.
- Sounds strange but changes in the level of interest risk also pose one of the key risks of futures trading. How is that? There are two ways. For example, the futures price includes an interest component and if the interest rates increase, the gap between futures and spot increases. If you are short future, you could be in trouble. This also becomes one of the important risks of futures trading because banks are heavyweights and futures on banks and Bank Niftyget impacted by movement in interest rates.
- This is true of all assets classes, but when you are leveraged, liquidity becomes a bigger risk. What if you want to sell but don’t find buyers? What if you want to buy back but don’t find sellers. Both these are significant risks of futures trading and can cause a dent in your profits.
- Spread risk is an extension of the liquidity risk we just discussed. Liquidity is the absence of counter buyers or sellers. In spread risk, there are counter buyers and sellers, but they are offering at prices that are far from the current price. That poses a spread risk and can be one of the important risks of futures trading in mid-cap futures.
- Execution risks are quite common. We will look at this risk in two parts. Firstly, there are common errors in execution that may happen. For example, you may buy futures instead of selling futures. You may end up buying the wrong contract or you may end up buying the wrong expiry. You may place a market order and the actual execution may take place much worse than your intended price. All these are routine risks. Then there are market-level fat-finger risks. We have seen that happen occasionally wherein some big trader or broker commits a trading error and that spooks the prices across the market. This kind of risk of futures trading impact all concerned.
- Don’t forget the MTM risk wherein you have to pay up the notional losses on futures daily. You need to plan your liquidity accordingly; else you could end up being in trouble with fund shortfalls and forced closure of futures positions.
- Finally, there is the settlement risk that arises from a lot of routine factors. There is no exchange settlement risk, as trades are counter guaranteed by the clearing corporation. But we have seen cases where mid-sized brokers have defaulted resulting in prolonged litigation and lock-in of funds for customers with open futures positions in the market.
How to settle a futures contract
There are different ways to settle a futures contract. For example, if you are long on futures or short on futures, you can just reverse the position by taking a counter position. This is the most common method of settling your futures contract. The second method is by just leaving your position to expiry. If you are holding May-futures, then the position automatically expires on the last Thursday of the month. But the only risk here is that the final settlement price you will get is subject to volatility and hence it is best to have control and closeout positions on your own.
How to do derivatives trading
Derivatives trading is largely like cash market trading. The only difference is that in derivatives trading your price is not the price of the stock but the price of the futures or the option price. Also, derivatives trading is a contract and there is no ownership. Just like in cash market trading, you must start derivatives trading by opening your trading account and activating online trading. It is quite simple, once you understand the entire process.
