How do futures work to protect a position?

Futures contracts are agreements to buy or sell an asset at a predetermined price and a predefined date in the future. These instruments enable businesses, investors, and speculators to manage their portfolios by protecting them against adverse prices of commodities, indices, currencies and other assets. Futures protect from market volatility and potential gains when correctly utilised. This article will discuss how futures work to protect a position in Singapore.

Hedging

Hedging is one of the primary reasons for using futures contracts. It helps limit an investment’s exposure to risk by locking in current prices on the open market while simultaneously helping to avoid losses due to sudden price changes over time. It benefits investors relying heavily on commodities, indices, currencies, and derivatives. Additionally, investors can use hedging to avoid potential losses from changing interest rates, currency exchange rate fluctuations and stability of government policies.

Length of Contract

The length of a futures contract is an essential factor in how it works to protect a position. Contracts usually last three months, although some exchanges offer six-month contracts. It allows for flexibility when planning investments and helps investors guard against volatility in the short term. For example, suppose an investor expects the price of a commodity or index to increase over the next few months. In that case, they may purchase a futures contract with longer maturities to take advantage of the expected appreciation without investing in stocks immediately.

Arbitrage

Arbitrage provides a way to exploit price discrepancies between two markets to take advantage of the price difference. For example, an investor may purchase a futures contract at a lower price in one market and sell it at a higher price in another market. It will help them find opportunities from the spread between the two markets. Moreover, traders can use arbitrage to protect their position by taking advantage of price discrepancies between two markets, allowing them to limit possible losses.

Speculation

Speculating in futures contracts is another way to protect a position. It involves purchasing or selling the asset at a predetermined price in the future with no intention of actually taking delivery of it. Investors can take advantage of price fluctuations without exposure to the asset itself. For example, suppose an investor believes that the price of a commodity will increase over time. In that case, they can buy a futures contract and benefit from any appreciation before the expiration date, even if they never take possession of it.

Leverage

Leverage allows investors to increase their exposure without increasing their capital. Investors can take more significant positions with less money and potentially make higher-value trades but also face more significant risks. However, investors can use leverage to protect their position by allowing them to take more significant positions while only investing a portion of the total amount. For instance, if an investor believes that a commodity’s price will decline over time, they could buy a futures contract with leverage to minimise potential losses if the price drops more than expected.

Disadvantages of using futures

While there are several advantages to using futures, there are also some potential risks. As with any investment tool, investors must be aware of the risks they may face when entering into a futures contract to ensure they are fully prepared.

Price Volatility

Futures contracts are subject to price volatility, and if the market moves against an investor’s position, they could face losses. For example, suppose an investor buys a futures contract expecting the asset’s price to increase over time. In that case, they may be unable to close out the trade if the price unexpectedly drops below their purchase price.

Leverage

Leverage also has potential risks, as it magnifies gains but can also magnify losses, which means that investors must ensure they are comfortable taking on more significant positions than their capital allows before entering into a futures contract.

Liquidity Risk

Liquidity risk is another potential issue, as the futures markets can be less liquid than spot markets. Sometimes, there may only be enough buyers and sellers to match orders, which could result in difficulty closing out positions or an inability to do so at an advantageous price.

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