Understanding Risk in Futures Trading
Understanding the risks involved in futures trading is important for traders when managing exposure in highly leveraged markets. First and foremost, since trading futures and other financial vehicles is inherently risky, only risk capital should be used for futures trading.
What is Risk Capital?
Risk capital consists of funds set aside for speculative trading which could be lost entirely in the process. Generally used for high-risk, high-reward investing, risk capital is money that would not have an unduly harmful financial impact on the investor if lost completely.
Factors which influence a trader’s risk capital include risk tolerance, age, experience and portfolio size.
Risk of Trading with Leverage
One major risk associated with futures trading is leverage. Leverage is inherent in futures trading and refers to the ability to control a high-value contract with a much smaller investment through the use of borrowed capital. This boosts a trader’s buying power and allows traders to control large positions with minimal risk capital.
While leverage is what makes futures trading so opportunistic, it is crucial for traders to understand how it works as well as the role of futures margins.
Financial leverage can result in losses greater than the funds deposited with a broker, and traders should take appropriate measures to minimize risk when trading unpredictable markets.
Low Liquidity & Slippage
Another risk in futures trading is low liquidity. Liquidity refers to the number of active participants within a market and is tracked using volume, open interest, and order book data. While many markets such as E-mini equity index futures are highly liquid round-the-clock, it is nevertheless important for futures traders to understand the potential risk of low liquidity.
Low liquidity can make it difficult for traders to enter & exit a futures market. Therefore, even with a strong trade thesis, low liquidity can make it difficult for a trader to execute a strategy.
Slippage is the difference between a desired or specified price and the price where a trade is actually filled, and most often works against the trader. Slippage also tends to occur more often in times of low liquidity. Thus, trading illiquid markets can potentially increase the chance of slippage.
Traders should choose contracts with appropriate liquidity for their trading style, position size and risk tolerance, allowing flexibility in their strategy while reducing the chances of slippage.
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