Risk associated with exchange-traded derivatives such as futures and options
Futures contracts cannot be sold like stocks or bonds. They generally must be liquidated by the investor entering into an equivalent but opposite position in another contract month, on another market, or in the underlying commodity. If a position in a futures contract cannot be liquidated, the investor may not be able to realize a gain in the value of the position or prevent losses from mounting.
An exchange may set a maximum daily limit on market price increases and decreases, and will halt trading when the limit is reached. Markets may be lock limit for more than one day, resulting in substantial losses to futures investors who may find it impossible to liquidate losing futures positions. Even if the investor can liquidate the position, it may be at a price that involves a large loss. For the same reasons, it may also be difficult or impossible to manage risk from open futures positions by entering into offsetting positions.
An alternative method of participating in futures trading is through a commodity pool, which is a pooled investment vehicle that invests in commodities and, typically, securities as well.
Futures Markets
A commodity pool participant will not have an individual trading account. Instead, the funds of all pool participants are combined and traded as a single account. Each investor shares in the profits or losses of the pool in proportion to his or her investment in the pool. Although commodity pools can offer benefits such as greater diversification among commodities than an investor might obtain in an individual trading account, the absence of margin calls, and a limitation on losses to the amount invested, the risks a pool incurs in any given futures transaction are no different than the risks incurred by an individual trader.
The pool still trades in futures contracts which are highly leveraged and in markets that can be highly volatile. And like an individual trader, the pool can suffer substantial losses as well as realize substantial profits. Trading in security futures contracts requires knowledge of both the securities and the futures markets. Under certain market conditions, the prices of security futures contracts may not maintain their customary or anticipated relationships to the prices of the underlying security or index.
These pricing disparities could occur, for example, when the market for the security futures contract is illiquid, when the primary market for the underlying security is closed, or when the reporting of transactions in the underlying security has been delayed.
Futures and Options
For index products, it could also occur when trading is delayed or halted in some or all of the securities that make up the index. The investor may be required to settle certain security futures contracts with physical delivery of the underlying security. If a position in a physically settled security futures contract is held until the end of the last trading day prior to expiration, the investor will be obligated to make or take delivery of the underlying securities, which could involve additional costs.
Although security futures contracts share some characteristics with options on securities options contracts , these products are also different in a number of ways. The purchaser of an options contract has the right, but not the obligation, to buy or sell a security prior to the expiration date. The seller of an options contract has the obligation to buy or sell a security prior to the expiration date. By contrast, if an investor has a position in a security futures contract either long or short , the investor has both the right and the obligation to buy or sell a security at a future date.
The only way to avoid the obligation incurred by the security futures contract is to liquidate the position with an offsetting contract. A person purchasing an options contract runs the risk of losing the purchase price premium for the option contract. Because it is a wasting asset, the purchaser of an options contract who neither liquidates the options contract in the secondary market nor exercises it at or prior to expiration will necessarily lose his or her entire investment in the options contract.
However, a purchaser of an options contract cannot lose more than the amount of the premium.
Futures and Options Markets
Conversely, the seller of an options contract receives the premium and assumes the risk that he or she will be required to buy or sell the underlying security on or prior to the expiration date, in which event his or her losses may exceed the amount of the premium received. Although the seller of an options contract is required to deposit margin to reflect the risk of its obligation, he or she may lose many times his or her initial margin deposit. By contrast, the purchaser and seller of a security futures contract each enter into an agreement to buy or sell a specific quantity of shares in the underlying security.
Based upon the movement in prices of the underlying security, a person who holds a position in a security futures contract can gain or lose many times his or her initial margin deposit. In this respect, the benefits of a security futures contract are similar to the benefits of purchasing an option, while the risks of entering into a security futures contract are similar to the risks of selling an option. Foreign currencies or baskets of currencies may be very volatile and may experience significant drops in value over a short period of time. The value of a foreign currency will depend, among other economic indicators, on movements in exchange rates.
Risks and special considerations with respect to foreign currencies include, but are not limited to, economic uncertainties, currency devaluations, political and social uncertainties, exchange control regulations, high rates of interest, a history of government and private sector defaults, significant government influence on the economy, less rigorous regulatory and accounting standards than in the United States, relatively less developed financial and other systems and limited liquidity and higher price volatility of the related securities markets.
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Taiwan, China. Channel Islands. German y. United Kingdom. Saudi Arabia. South Africa. United Arab Emirates. We no longer support this browser. Using a supported browser will provide a better experience. To the extent the obligations or rights in respect of an OTC Derivative are linked to prices or values in a particular market, the investor will be exposed to a risk of loss as a result of price or value movements in that market. Credit Risk. Non-Transferability and Non-Marketability. There will be no public market for OTC Derivatives.
Many funds use futures, options and swaps in executing strategies.
OTC Derivatives generally cannot be assigned or transferred by a party without the prior written consent of the other party. It therefore may be impossible for the investor to liquidate a position in an OTC Derivative prior to maturity. Because OTC Derivatives are not standardized, engaging in another OTC Derivative transaction to offset an OTC Derivative the investor has entered into with JPMCB will not automatically close out those positions as may be true in the case of exchange traded futures and options and will not necessarily function as an effective hedge.
Option Risk. Option transactions can be very risky. The risk of selling writing options is considerably greater than the risk involved in buying options. If an investor buys an option, the investor cannot lose more than the premium. If an investor sells writes an option, the risk can be unlimited. Fluctuations in currency exchange rates may affect the value of any OTC Option on securities trading in or denominated in a foreign currency, as well as the value of any payment or delivery of securities in connection with such OTC Option.
Fluctuations in currency exchange rates may affect the value of any payment or delivery of securities in connection with such OTC Option. Leverage Risk. Certain derivatives can be structured to allow for significant leverage. Additional collateral may be required after the investor has entered into an OTC Derivative. Special Statement for Uncovered Option Writers There are special risks associated with uncovered option writing which expose the investor to potentially significant loss.
The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument increases above the exercise price. Companies that shun the use of derivatives hamper the ability of their financial staffs to provide basic services. Those that relax constraints without losing sight of fundamentals stand to reap significant rewards. For the last 15 years, he has specialized in derivatives-related issues for major corporations and dealers.
How should CEOs respond when their chief financial officers propose that the company initiate or expand the use of financial derivatives? However, before embracing that position and turning the financial staff loose, CEOs must analyze what an active derivatives program would mean to the company and how such a program could be controlled.
Once authorized, trading in these instruments takes on a life of its own. Decisions to use derivatives are sometimes made in minutes or even seconds, and they may only involve a trader who alone understands the transaction. But the financial commitment may be large and long term. Derivatives can be unforgiving. They require managers who will actively help develop and implement detailed instrument- and risk-specific board policies and who will strictly enforce compliance. CEOs should recognize that derivatives are not merely another corporate strategy for managers and employees to implement.
The presence of experienced trading personnel is a good start, but it may not be enough.