Among the many advantages of futures trading is its utility in regard to risk management. Futures give market participants the ability to directly increase or decrease exposure to almost any asset class. This is possible because of three primary futures market characteristics: standardization, liquidity, and volatility. Given these benefits, traders may proactively limit risk by entering and exiting the market efficiently at their leisure.
One of the key advantages of futures trading is that all trade is standardized. This means that transactions are cleared through a formal exchange, eliminating the risk of counterparty default. In addition, every contract is issued with a distinct quantity and expiration date, thus eliminating any guesswork regarding valuation. If you are buying one lot of 2020 September corn (ZC), then you are purchasing a contract for 5,000 bushels that ceases trade on September 14, 2020.
Participants in other markets do not enjoy this degree of clarity. In the spot and over-the-counter (OTC) markets, transactions can be nondescript, and the risk of counterparty default is real.
For example, assume a corn producer agrees to sell a portion of the upcoming harvest to a credit buyer. If the buyer defaults on the obligation, the producer is left out in the cold. On the buyer side of the equation, issues such as product quality and regional pricing can impact the value of the exchange. Given the customizable nature of OTC and spot transactions, they are often much riskier than exchange-based trade.
If you have ever tried to buy or sell an expensive item such as land, a house, or a business, then you can attest to the challenges of market liquidity. Fortunately for active traders, liquidity is among the leading advantages of trading futures.
Markets with robust liquidity have two features that are extremely valuable for reducing financial risk:
- Pricing efficiency: Liquid markets exhibit a high degree of public interest and participation. As a result, the process of price discovery may be carried out in an efficient manner. The risks of market manipulation and outright fraud are reduced exponentially because the sheer number of participants promotes “fair” pricing.
- Ease of exit: In any business deal, the ability to get out when things aren’t going well is a critical part of managing risk. Liquid markets afford participants the luxury of quickly closing out open positions when warranted. Illiquid markets do not, thus opening the door to financial catastrophe.
For futures traders, liquidity is scarcely a problem. In fact, the CME’s 2019 average daily traded volume measured 19.2 million contracts. Essentially, no matter which asset class you’re trading, chances are you can exit the market anytime at a reasonable price.
It may seem like a counterintuitive point, but pricing volatility can actually help to manage risk. One of the key advantages of futures trading is the flexibility to take long or short positions as needed. Given an appropriate strategy, fluctuations in futures contract pricing can help limit risk exposure in other markets.
To illustrate how futures volatility may be used to manage risk, assume that Tristin owns a freight delivery company based in Topeka, Kansas. Unfortunately, Tristin’s business has been on the downswing because of losses stemming from higher fuel costs. To limit these losses, Tristin decides to buy 10 contracts of 12-month deferred West Texas Intermediate (WTI) crude oil futures. Bullish volatility in the crude oil markets will generate positive income, largely offsetting losses incurred by rising refined fuel prices.
Capitalize on the Many Advantages of Futures Trading
The futures markets offer participants a vast array of risk management applications. To learn more about how futures can help you guard against the unknown, check out Daniels Trading’s online hedge portal today.