Futures: Risk levels of participants.

Future contracts, as we have already seen, are instruments used for ‘transferring risk’. In other words, future contracts are basically used for Financial risk management.

That brings us to one basic question. When and for whom is risk management necessary? Risk management is necessary only for those who have a risky asset position. I.e., when you have assets (shares / gold / currency / commodity etc) which fluctuates heavily in value. The uncertainty of price movements that surrounds such investments necessitates the use of derivatives. Many examples were discussed in our early posts on how derivatives help investors in reducing the risk they face.

The point i would like to bring here is that you should be very clear about why you are using derivatives.

Many investors, I’ve seen, use derivatives purely in pursuit of windfall gains. This is where the danger is.Many individuals and corporates have gone bankrupt because of reckless speculation in derivatives market. Way back in 1936, the dangers of speculation was explained by economist J M Keynes.  The excerpt is given below-

JOHN MAYNARD KEYNES – ON SPECULATION

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.”

“It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”J.M Keynes- From his book “The general theory of employment, interest and money”.

The above situation holds true for all those uninformed traders who take positions in derivatives market expecting to make huge money.

World over, the misuse of derivatives is on the rise.  Misuse of these financial instruments contributed significantly to the global financial crisis in 2008. Newspapers and internet carry advertisements of advisory firms which provide futures and options calls with “90% or more success rate”. Naïve investors are lured to trade in derivatives by these firms. When many participants unnecessarily bet in different directions, the volatility in the market increases. Add to that those events like scams that occur across the finance world.  All put together, sudden upward surges and downfalls occur which wipes off the wealth of many families and corporates.

Speculation is part and parcel of every market. No system can control or curb speculation. In fact,there is no need to control them. Speculators of the first and second degree are required for the smooth functioning of the markets. They provide the much required volume and liquidity. But, when you put your money anticipating what average opinion expects the average opinion to be’, you’ve gone too far. Opt for derivatives only if you have a genuine purpose of doing so. If you have a cash position or a heavy portfolio, you’ll have to protect it from the vagaries of price fluctuations. In such cases, you can use the derivatives route to reduce your risk so that when you lose on one, you gain on the other and thus neutralize the effect. You may also gain from favorable price movements.

If you are using derivatives as a quick route to huge wealth, you are totally caught on the wrong side. In this case, your risk is substantial.Derivatives have the potential to evaporate all your money in seconds.

In short, amateurs and speculators are the participants who would lose/ earn money depending on their stars or destiny. For them, the risk level is high. Other participants like arbitrageurs, spreaders and hedgers are in – with a purpose.

You may like these posts:

  1. Who plays in this market?
  2. Why do derivatives market exist?
  3. Futures: Arbitrage & its meaning.

5 Responses to “Futures: Risk levels of participants.”

Atul

May 13, 2012 at 10:58 am

Dear your articles are very informative especially for beginners. You always try to simplify the concept therefore making it possible for beginners to understand the topic deeply and go through it without complexities.

Santa Banta

May 13, 2012 at 11:00 am

I’m a new visitor who discovered this great site from Google. I thank you so much for sharing this great information.

Abhishekh Jadhavan

May 13, 2012 at 11:03 am

Victor,

I would like to ask you one query here. Where can I get more information about the ‘Futures’? Actually I’m kinda new in shares and I heard this term several time from dealers. But he never gave as much as detailed information as you have provided here. So please help me understand what exactly ‘Future’ means.
Thank you.

Best wishes,
Abhi

J Victor

May 13, 2012 at 6:12 pm

Hi Abhishek .. read it here

http://www.sharemarketschool.com/types-of-derivatives-futures-contract/

J Victor

May 13, 2012 at 6:13 pm

hi atul..Thanks a lot :)

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