Managing Risk

Written by Aaron Adam

Investors who are trading futures contracts should be fully aware of the various risks these transactions carry. This is particularly important because many novice investors get tripped up by misunderstandings concerning margin. If you're trading futures, it is possible to lose not only the initial margin amount, but also the full amount you've deposited in your margin account.

Fortunately, there are a number of methods futures traders can employ to reduce their risk of loss, but no futures trading strategy is 100 percent risk free, however.

Picking the right contract

Futures contracts are similar to stocks and bonds in that the investor is exposed to varying degrees of probable risk and reward. Some commodities may be more volatile than others because of various fundamentals such as weather, labor conditions and geopolitics, among other factors. Changes in these fundamentals can result in spikes and dips in the price of the underlying commodity. Investors should be able to use current information to evaluate and pick futures contracts that look like a solid choice to help you meet your investing objectives. Past nor present prices are reliable predictors of future prices, but from studying a commodity's chart, certain patterns can be discerned.

Understanding liquidity and timing

In the futures market, there are no guarantees that a liquid market will be there to help investors offset a futures contract that he or she has previously bough or sold. In short, there might not always be a buyer or a seller for the futures contract you want to trade. When selecting a futures contract, you should take a look at the volume of trading and open interest to get a good idea of the liquidity in the specific commodity you're trading. This information is often carried in newspapers and Web sites.

Successful futures traders must be able to predict not only the direction of prices, but also when prices will spike or dip. If a price dips just before the contract is up, or spikes and you've predicted the opposite, it doesn't matter if the price corrects later because you've already suffered a loss because your timing was off.

Risk avoidance

There's a number of mechanisms you can use to limit your exposure to risk:

Stop order: A stop order is an order placed with your broker to buy or sell a futures contract at market price when that price crosses a certain threshold. Futures traders use these orders to limit their losses if futures prices move adverse to their open position. For example, if you bought a wheat futures contract at $3 per bushel and wished to limit your potential for loss to $1 per barrel, you would place a stop order compelling your broker to sell the contract if the price fell to $2 per bushel. Conversely, if you had opened a short position, betting on the price to drop, you might set a stop order at $4 per bushel should the price of wheat appreciate.

Just because you've set a stop order at a certain amount, it doesn't mean you'll get that price if your broker has to sell. Rapid dips may drag the price under your stop order, and should that be the case, your broker is only required to make the sale at the best immediately obtainable price.

Spreads: Spreads are basically the practice of buying one futures contract and selling a similar one with the goal of profiting from a narrowing or widening of the price between the two contracts. Profits and losses are caused by changes in the price difference, rather than an overall increase or decline in the price of the underlying commodity. This makes spreads less risky than conventional long or short positions in the futures market.

Options: An option allows futures traders to purchase the right, but not the obligation, to buy or sell a futures contract. This is less risky because the trader is not obligated to buy or sell the contract. However, profits from this method of trading futures can be negatively impacted by the price of purchasing the option.

There are two types of options, call options and put options. Call options give the trader the right to purchase a futures contract at a set price at any time during the length of the call option agreement. For example a call option could give a trader the right to purchase corn at $4 per bushel at any time during the life of the option. One motivation for placing a call option is to profit from an anticipated spike in the price of the underlying commodity. For example, a call option trader buying the right to purchase corn at $4 per bushel would profit if during the option period the price of corn jumped to $6 per bushel and the investor exercised the option.

Put options give the futures trader the right to take up a short position on a futures contract at a set price. Investors buying put options seek to profit from drops in the price of the underlying commodity. For example, a trader seeking to profit from a decline in wheat prices might pay a premium for the right to sell a wheat futures contract at $4 per bushel in October. At expiration, the price of wheat has declined to $1 per bushel, but because you have the option to sell at $4 per bushel, you profit. However if the price rose, you wouldn't be obligated to sell the contract, and your only loss would have been the premium price you paid for the option.

With smart investing, and risk management tools such as options, spreads and stop orders, futures traders can work to increase their odds of making a profit and decrease their risk of a loss.