Futures are derivative contracts that allow for the sale of an asset at a future date at a predetermined price. They protect the traders from incurring massive losses which might happen after a sharp decline in the stock prices. By entering into a futures contract, they ensure to minimise their risk exposures.
It is unfair to call these contracts riskier in comparison to other financial instruments. However, futures contracts are believed to be, somewhat, risky because they give exposure to speculative positions with a large amount of leverage.
When seen from the perspective of a trader, futures contract limit the exposure to risk in a trade. For instance, when a company’s shares are sold for ₹100 today. A trader, uncertain about the future of shares, can buy a futures contract for ₹90. This saves the trader from selling the stock for, say, ₹60 if the price falls. So, one of the key advantages of futures contracts is that it takes away the element of uncertainty in the asset’s future price.
Risks and Advantages
A key reason that determines the risk and advantages of futures contract is the quantum of leverage. Leverage is the scope of margin investment made by putting in only a small portion of total value. Although the maximum leverage can not exceed 50 percent in stocks, the percentage can be as high as 90 percent in futures contracts.
In other words, one can put only 10 percent of the contract value for exposure of 100 percent of stock value. This means that a small investment of margin can lead to the possibility of large losses, as well as of whopping profits. This can happen because the leverage increases the impact of any price changes manifold. One can, in fact, earn more profits or incur more losses than the original investment made.
To summarise, a trader can rely on futures contracts to cut down on risk by hedging their position. Having said this, the futures contracts expose the investors to a greater degree of leverage – and hence, run the risk of incurring higher losses. This makes them, arguably, riskier than the normal stocks.