Risks of Futures, Commodities Future Trading - Risks, Commodities Futures, Commodities Markets, Commodities Future Trading   Risks of Futures, Commodities Future Trading - Risks, Commodities Futures, Commodities Markets, Commodities Future Trading 
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Risks of Futures

Home > Commodities & Futures > Risks of Futures

Risk and margin
Risks of Futures, Commodities Future Trading - Risks, Commodities Futures, Commodities Markets, Commodities Future Trading
In a futures market, the commitment to make or take delivery must be accompanied by a quantity of cash called the margin deposit. The margin is defined as a sum for good faith, deposited to back up your commitment with evidence of financial capability.

One of the most critical facts of the futures markets from a speculator's point of view is that the margin deposit represents a small fraction of the full value of the commodity committed for. If you are long July wheat at $4 per bushel, you are committed to take delivery of $20,000 worth of merchandise $4 x 5,000 bushels (wheat is sold in standard contracts of 5,000 bushels). The margin required for such a transaction is typically around $2,000 or 10 percent of the full contract value.

If the speculator thinks of the margin deposit as the investment, then the price level of the futures contract must change by only 10 percent for him or her to make 100 percent profit or to lose the entire initial investment on the trade. Now think about it again. It should be obvious that with such leverage you can make an enormous amount of money in the futures markets. You can also lose an equally large amount.

In the above example, if wheat traded as high as $6 per bushel, the speculator who went long $4 could make as much as $10,000 on a $2,000 investment. The stubborn speculator who went short would, having fought the market all the way, have lost $10,000, or five times the original investment. You can see that selling short on margin carries enormous financial risks.

Let us assume you are about to make a trade. We presume that you have sought to identify a trending market, that you have arrived at some conclusion as to the length or breadth of the move based on supply and demand, and that you have confirmed and refined your fundamental analysis by thoroughly examining the market's technical aspects. All that remains is to apply a money-management strategy. The easiest way to begin is to ask the question "Is the expected profit worth it? What does this mean?" It means that you ask, "Is the risk I'm about to take when I establish this position worthwhile when compared with the amount of money I'm going to make if I'm right?"

Next comes the question, "What is the risk?" Our advice is to allow it to be determined by the market and then to adjust your trading accordingly rather than vice versa. For example, if you decided that gold was poised for an advance from a prevailing level of $450, what is the risk? You should not begin by arbitrarily declaring that you will not lose more than $1,000 per contract and then placing a stop at $440. Rather, you should figure out at what point the market itself would prove that predictions indicating the market is heading higher are not correct. The risk level, or the stop loss, should be at a level where you must abandon your opinion about the trend of the market.

You may arrive at that risk level through fundamental analysis or technical analysis examining charts to locate areas of support or resistance. In technical analysis, the support area is a price level the commodity has previously reached, below which it will tend not to fall, often a level at which a lot of buying had taken place previously. The resistance area is a price level the commodity has previously reached, above which it will tend not to rise, often a level at which a lot of selling had previously taken place.

Strategies for reducing risk
Traders should seek situations that could result in major profits. Once the trade is initiated, considerable patience may be needed in order for such profits to be realized. Cut your losses and let your profits run. This maxim is a useful key to successful trading in commodities. Although most successful futures traders will experience more losing trades than winners, they succeed because they make the occasional major profit. The following strategies detail how you can put this maxim to use:

The whole idea is to find a winner and ride with it, buying more as the price goes up, but always keeping your average price well below the current price. For example, suppose you buy three sugar contracts at 10 cents per pound and the market starts moving upward. Of course, you have the right to buy more at any time, but you want to keep your average price well below the current price. Therefore, a good strategy might be to buy one more contract at 12 cents and another at 15 cents. At this point you would have five contracts at an average price of 11.4 cents per pound, giving profit protection of 15 - 11.4 = 3.6 cents per pound. Then, if sugar falls in price by an amount you had predetermined for instance, 1 cent per pound from its high you would sell out, getting a profit, in this case, of 5 x 2.6 Cents per pound x 112,000 pounds (the size of the contract) = $14,500.

The wrong approach would be to buy three at 10 cents and then five at 15 cents. Obviously, a slip in the market price to 14 cents would cancel out most of the profit built up during the risk from 10 cents to 15 cents. This situation is called being top heavy and should be avoided.

This example has shown that the profits made from riding a commodity upward can be very large, thus more than compensating for frequent small losses taken when commodities move against you initially.

Averaging down, another strategy commonly used in the stock market, should never be used in the futures business. If a stock looked good at $10 a share, its value should be even greater at $8, but the reverse is true of a commodity. If a commodity starts to go against you, always offset positions. Never add to positions.

Every speculator in futures must understand the implications of limit trading. A futures contract differs from a stock in that a stock may move up or down according to demand, but a futures contract is allowed to fluctuate only within strict limits each day. For example, suppose January sugar trades at around 18 cents per pound -- in one day's trading it may not move up or down more than 2 cents, that is, if it closes one day at 18 cents, the next day it would not be allowed to go above 20 cents or below 16 cents.

The purpose of this limit is to prevent a panic from driving a commodity price beyond its real value. The danger to you, the speculator, is that as a commodity moves against you day after day, you may not be able to sell out. If some terrible disaster ruined the sugar crop, the sugar that closed last night at 18 cents will close tonight at 20 cents and the next day at 22 cents without a single contract changing hands, and there can be lengthy periods of time in which you are trapped and cannot get out.

Never buy a commodity that has just undergone a large rise, because the possibility of an equally large and sudden reversal is always present, and the risk is just too great. Those purchases should be left for the professional and the hedger.

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