FUTURES ADVANTAGE
The existence and the utility of a futures market benefits a lot of market participants
- It allows hedgers to shift risks to speculators.
- It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
- Based on the current future price, it helps in determining the future demand and supply of the shares.
Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin for the purchase of the contract instead of the entire value of physical holdings.
RISKS INVOLVED IN FUTURES CONTRACTS
Futures trading is inherently risky and requires that participants, especially brokers, are not only familiar will all the risks but also possess the skills to manage those risks. Following are the risks associated with trading futures contracts:
Leverage
One of the chief risks associated with futures trading comes from the inherent feature of leverage. Lack of respect for leverage and the risks associated with it is often the most common cause for losses in futures trading. Exchange sets margins at levels which are deemed appropriate for managing risks at clearinghouse level. This is the minimum level of margins required by the exchange and provides maximum leverage. For example, if the initial margin for gold is 2.5%, it implied 40 times leverage. In other words, a trader can take a position equivalent to Rs. 100,000 by only depositing Rs. 2,500 in his or her account. Clearly, this represents great amount of leverage which is defined as the ability to take large exposures with little upfront cost.
Interest Rate Risk
The risk that an investment's value will change due to a change in the absolute level of interest rates. Normally, rise in interest rates during the investment period may result in reduced prices of the held securities.
Liquidity Risk
Liquidity risk is an important factor in trading. Level of liquidity in a contract can impact the decision to trade or not. Even if a trader arrives at a strong trading view, he may not be able to execute the strategy due to lack of liquidity. There may not be enough opposite interest in the market at the right price to initiate a trade. Even if a trade is executed, there is always a risk that it can become difficult or costly to exit from positions in illiquid contracts.
Settlement and Delivery Risk
All executed trades need to be settled and closed at some point. Daily settlement takes the form of automatic debits and credits between accounts with any shortfalls being recovered through margin calls. Brokers are obligated to fulfill all margin calls. Use of electronic systems with online banking has reduced the risks of failed daily settlements. However, non-payment of margin calls by clients poses a serious risk for brokers
In cases where clients fail to pay margin calls, brokers need to be proactive and take steps to close out positions. Managing risks of client non-payment is an internal broker function that should be done in real-time. Delayed response to client delinquency can result in the creating losses for brokers if not default.
Operational Risk
Operational risk is a major source of losses for brokers as well as investor complaints. Errors due to manual mistakes by staff are a major area of risk for all brokers. Measures like adequate staff training, supervision, internal controls, and documentation of standard operating procedures and segregation of tasks are essential for running a brokerage house as well as for reducing instances and impact of operational risks.
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