Pricing Structure Of Futures Contract & Risk Management

Futures contracts, like other financial instruments, involve risk. However, the risk associated with a futures contract is more easily managed than with other types of investments because of the ebb and flow of prices during different periods. Futures contracts are standardized agreements to buy or sell a specific commodity at a particular point in the future (pre-set date) and at a set price. The value of a futures contract fluctuates according to the supply and demand for that particular commodity. As such, the pricing structure of the futures contract will be either greater than or less than the pre-set price when it expires. Understanding the risks in investing in futures contracts helps you manage them effectively and maximize your profits.

Why is Risk Management Important?

The price fluctuations of stocks and bonds are relatively consistent. They can be used as an indicator of an investment's potential risk and reward. However, there is no guarantee that those fluctuations will be accurate. The risk of commodity prices fluctuating is a larger concern for the investor, particularly in the case of agricultural products such as wheat, corn, coffee, and so on. The price of these commodities is subject to more short-term fluctuations, which can cause significant losses to investors. The fluctuations in the price of futures contracts are easier to predict than fluctuations in the price of the commodities themselves. Futures contracts are standardized and have expiration dates. This makes the pricing structure of futures contracts easier to value and trade. The risk of price fluctuations is greater, but there are also opportunities to minimize the risk by trading with a well-thought-out strategy.

Types of Risk in Futures Contracts

The market price of the underlying commodity has a huge impact on the pricing structure of the futures contract. This makes a futures contract very risky. What if the price of the commodity falls below the price agreed upon in the futures contract? If the contractual obligations are held to be fulfilled, this could result in a loss for the investor. What if the commodity's market price increases above the price set in the futures contract? If the parties are still obliged to fulfill the contract, this could result in a loss for the investor.

- Price Risk: The price of the commodity at the end of the contract is uncertain. Although the pricing structure of the futures contract is set at the beginning of the contract, the price of the commodity itself may change. The investor will incur a loss if the commodity price rises above the price set in the futures contract. The investor will incur a loss if the commodity price falls below the price set in the futures contract.

- Risk of Receipt: The investor must physically deliver the commodity at the contract's expiration, regardless of the current market price. If the commodity's market price is lower than the futures contract price, the investor could incur a loss.

- Risk of Default: If one of the parties to the futures contract fails to fulfill the contractual obligation, the investor may incur a loss. The insolvency of a broker is one of the main reasons for default. Unfortunately, this is a risk that is difficult to guard against.

Expiration Month Risk Analysis

This is the risk that a futures contract will expire before it can be closed with an offsetting contract. The pricing structure of a futures contract may rise above the price set in the contract if there is a sufficient supply of the commodity. Conversely, the pricing structure of a futures contract may fall below the price set in the contract if the supply is insufficient. A futures contract for the same commodity in a different month may be traded as an offsetting position (to close out the existing futures contract and reduce risk). This can protect against the risk of expiration, but the futures contract in another month may also have a price that moves up or down. The risk of unfavorable price movements in the futures contract in the other month is referred to as "basis risk."

Strategies to Manage the Risk in Futures Contracts

A few strategies can be used to manage the risk in futures contracts.

- Hedging: Hedging involves taking an offsetting position in a futures contract in a different month. This can protect against the risk of expiration, but the futures contract in another month may also have a price that moves up or down. The risk of unfavorable price movements in the futures contract in the other month is referred to as "basis risk."

- Using Options to Manage the Risk in Futures Contracts: Using options to manage the risk in futures contracts can be a way to limit the risk associated with a position. However, options trading is extremely risky and should be used with great caution. It is advisable to seek professional advice before entering into any option contract.

How To Use Options 

An option is a contract that gives the holder the right to buy or sell a futures contract at a pre-set price on a pre-set date. For example, let's say an investor owns 50 corn futures contracts expiring in September. The price of each contract is $3.00. If the price of corn rises above $3.50, the investor will incur a loss. An option contract for corn expiring in September could be purchased for $0.05. The $0.05 is the option premium. If corn rises above $3.50, the futures contract price will be greater than $3.50. The option will be exercised, and the investor will have to sell 50 contracts at $3.50. The investor will have made a $0.05 profit per contract.

Conclusion

The market price of the underlying commodity has a huge impact on the pricing structure of the futures contract. This makes a futures contract very risky. What if the price of the commodity falls below the price agreed upon in the futures contract? If the contractual obligations are held to be fulfilled, this could result in a loss for the investor. What if the commodity's market price increases above the price set in the futures contract? If the parties are still obliged to fulfill the contract, this could result in a loss for the investor. The fluctuations in the price of futures contracts are easier to predict than fluctuations in the price of the commodities themselves. Futures contracts are standardized and have expiration dates. This makes the futures contract easier to value and trade. The risk of price fluctuations is greater, but there are also opportunities to minimize the risk by trading with a well-thought-out strategy. It is also important for all traders and investors in the financial markets to do their own research before they start investing their own capital for trades. You must ensure that you execute trades based on your risk appetite and capital amount.