Risks of trading futures
In planning any futures strategy, it is important to consider the risks of futures trading.
The leveraged exposure provided by futures can lead to substantial losses.
At the time of your opening transaction, your outlay is limited to the initial margin. This means that the percentage return, either positive or negative, made on your initial investment is far greater than the movement in the underlying index. If the market moves against you, the losses you will suffer from trading futures may be substantial.
Unlike option contracts, where the buyer of the option can lose no more than the cost of the premium, both the buyer and the seller of a futures contract face potentially unlimited losses. The futures contract is a legally binding agreement to buy or sell the underlying index at the agreed price, no matter what the level of the index is at maturity of the contract.
You should discuss with your investment adviser whether this risk is appropriate to your circumstances.
You may use index futures to hedge against the risk of either a rise or a fall in the underlying index. By selling index futures you can protect the value of a share portfolio. By buying index futures you can lock in the purchase price of the index at a future date.
The principle behind using futures to hedge is that a profit in one market, say the futures market, will offset a loss in the other market, the share market.
The success of any hedging strategy depends in part on how closely movements in the value of the shares being hedged track movements in the index underlying the futures contract. This is often referred to as basis risk.
For example, you may sell ASX Mini 50 Futures to lock in the value of your share portfolio. Even though your portfolio may contain a number of the shares in the S&P/ASX50 Index, it is unlikely to move exactly in line with the index. The change in value in your portfolio may not be offset exactly by the change in value of the futures contract. This may work in your favour, or it may work against you.
Another consideration is the amount you choose to hedge. The value of the share portfolio you wish to hedge may not equal an exact multiple of Index futures contracts. You will therefore have to choose between slightly over-hedging and slightly under-hedging your physical position.
Again, this discrepancy may work in your favour, or it may work against you, depending on how the market moves.
Risk Disclosure Statement
Your broker is required to give you certain information before allowing you to trade. Included in this information is a Risk Disclosure Statement setting out risks associated with futures trading.