Almost every futures adviser or experienced trader would tell you that trading futures is risky, and thus makes one wonder just how risky futures trading is.
I mean, if futures trading is so risky, why are so many people still doing it? Has anyone gone bankrupt from trading futures? And how exactly can we manage the risks of futures trading?
With this article, we shall adequately give answers to these questions and also 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?
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 has given futures trading its notorious reputation over the decades.
Inadequate management of these risks has made futures traders go bankrupt and most owe money from trading futures within a relatively short period.
That is why the Bitqt App is a great resource for trading because it provides traders with the information and strategies needed to make the right trade.
The risk of loss in futures trading can also come about due to other factors which we will explore in detail below.
Perhaps the main cause of risk in futures trading is the fact that trading futures expose 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.
Another factor that compounds risk 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.
Another liability is the fact that profit and losses are settled daily in futures trading at the end of each trading day. Daily settlement is supposed to be a risk control measure that 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 that is eventually profitable gets closed out prematurely due to losses on short-term whipsaw.
Trading Related Risks
Trading-related risks of futures trading have to do with your ability to make the correct futures trading decisions and actions. This means being able to make an 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 execution 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”.
Market-related risks apply to futures trading as well. Market-related risks consist of three main aspects: Systemic Risk, Secondary Risk, and Idiosyncratic Risk.
- Systemic 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 are.
- 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.
- 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). 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
Policies regulating futures trading change 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 things futures traders need to do.
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.
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.
Futures are not any riskier than other types of investments, such as owning equities, bonds, or currencies. However, the actual practice of trading futures is considered by many to be riskier than equity trading because of the leverage involved in futures trading.
To handle the additional leverage wisely, futures traders have to practice superior money management by using prudent stop-loss orders to limit potential losses. Good futures traders are careful not to over-margin themselves, but instead to maintain enough free, uncommitted investment capital to cover draw-downs in their total equity. Trading futures contracts require more trading skills and hands-on management than traditional equity investing.