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Anyone buying or selling futures contracts should clearly understand that any given transaction may result in a loss. The loss may exceed not only the amount of the initial margin but also the entire amount deposited in the account or more. Moreover, while there are a number of steps that can be taken in an effort to limit the size of possible losses, there can be no guarantees these steps will prove effective. Well-informed futures traders should be familiar with available risk management possibilities.
Choosing a Futures Contract
Just as different common stocks or different bonds may involve different degrees of probable risk and reward at a particular time, so may different futures contracts. The market for one commodity may, at present, be highly volatile, perhaps because of supply-demand uncertainties which—depending on future developments—could suddenly propel prices sharply higher or sharply lower. The market for some other commodity may currently be less volatile, with greater likelihood that prices will fluctuate in a narrower range. You should be able to evaluate and choose the futures contracts that appear—based on present information—most likely to meet your objectives, your willingness to accept risk and your expectations as to when the anticipated price change will occur.
Keep in mind, however, that neither past nor present price behavior provides assurance of what will occur in the future. Prices that have been relatively stable may become highly volatile (which is why many individuals and firms choose to hedge against the possibility of future price changes).
There can be no ironclad assurance that, at all times, a liquid market will exist for offsetting a futures contract that you have previously bought or sold. This could be the case, if a futures price has increased or decreased by the maximum allowable daily limit and there is no one presently willing to buy the futures contract you want to sell or sell the futures contract you want to buy.
Even on a day-to-day basis, some contracts and some delivery months tend to be more actively traded and liquid than others. Two useful indicators of liquidity are the volume of trading and the open interest (the number of open futures positions still remaining to be liquidated by an offsetting trade or satisfied by delivery). These figures are usually reported in newspapers that carry futures quotations. The information is also available from your broker or advisor and from online market reporting services and exchange web sites.
A stop order is an order, placed with your broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Stop orders are often used by futures traders in an effort to limit the amount they might lose if the futures price moves against their position. For example, were you to purchase a crude oil futures contract at $15 a barrel and wished to limit your loss to $1 a barrel, you might place a stop order to sell an offsetting contract if the price should fall to $14 a barrel. If and when the market reaches whatever price you specify, a stop order becomes an order to execute the desired trade at the best price immediately obtainable.
There can be no guarantee, however, that it will be possible under all market conditions to execute the order at the price specified. In an active, volatile market, the market price may be declining (or rising) so rapidly that there is no opportunity to liquidate your position at the stop price you have designated. Under these circumstances, the broker’s only obligation is to execute your order at the best price that is available.
In the event prices have risen or fallen by the maximum daily limit, and there is presently no trading in the contract (known as a “lock limit” market), it may not be possible to execute your order at any price. In addition, although it happens infrequently, it is possible that markets may be lock limit for more than one day, resulting in substantial losses to futures traders who may find it impossible to liquidate losing futures positions.
Subject to the kinds of limitations just discussed, stop orders can nonetheless provide a useful tool for the futures trader who seeks to limit his losses. Far more often than not, it will be possible for the broker to execute a stop order at or near the specified price.
In addition to providing a way to limit losses, stop orders can also be employed to protect profits. For instance, if you have bought crude oil futures at $15 a barrel and the price is now at $19 a barrel, you might wish to place a stop order to sell if and when the price declines to $18. This (again subject to the described limitations of stop orders) could protect $3 of your existing $4 profit while still allowing you to benefit from any continued increase in price.
As previously discussed, spreads involve the purchase of one futures contract and the sale of a different futures contract in the hope of profiting from a widening or narrowing of the price difference. Because gains and losses occur only as the result of a change in the price difference—rather than as a result of a change in the overall level of futures prices—spreads are often considered more conservative and less risky than having an outright long or short futures position. In general, as long as you are trading the same number of futures contracts, this may be the case.
It should be recognized, though, that the loss from a spread can be as great as—or even greater than—that which might be incurred by having an outright futures position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures prices, and it is possible to experience losses on both of the futures contracts involved (that is, on both legs of the spread).
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