Liquidity risk of futures trading
Liquidity is a crucial factor in determining the success of a futures market. A futures market must have enough participants with competing price goals buyers and sellers to ensure a turnover high enough to permit the buying and selling of contracts at a moment's notice without direct price distortion. Large transaction volumes provide flexibility liquidity and enable traders to pick the most appropriate contract month, corresponding to their physical delivery commitments, to hedge the price risks inherent in those physical transactions.
More bids to buy and offers to sell in the market at any given time create greater pricing efficiency for the participants seeking a price for the commodity. Currently only the New York and London markets liquidity risk of futures trading this flexibility on an international scale. Speculators and hedgers competing for price generally means that futures and cash prices move in the same direction over time and as a futures contract approaches delivery the futures price and the cash price will often converge.
Futures prices do not always reflect cash market reality though, especially over the very short term when large volumes may be traded for purely speculative reasons.
The volume of futures trading and the underlying quantity of physical coffee it represents easily exceed total production of green coffee, or indeed the volume of the physical trade as liquidity risk of futures trading whole.
The large volumes on the futures markets not only influence futures prices but inevitably have an influence on the price of physical coffee as well. It is important for those involved in the physical coffee business to be aware liquidity risk of futures trading the activity of speculators and derivative traders. For that reason, the futures industry regularly examines and publishes the ratio of liquidity risk of futures trading and hedging activity in the market.
Speculators are absolutely necessary to the efficient function of a futures liquidity risk of futures trading. Speculative activity directly improves liquidity and therefore serves the hedgers' liquidity risk of futures trading interests.
During the last ten years or so, the activity of hedge funds and the development of options on futures markets have both led to an increase in short-term speculative activity.
While options on futures provide another speculative opportunity in the futures market, options also represent an important risk management tool that has become very useful in recent years.
See also 09, Hedging and other operations. Not all options result in actual futures contracts. However, they do represent potential quantities to be traded on the strike dates should the holders decide to exercise their options rather than simply letting them expire. In any event, the large turnover in actual futures demonstrates the impact of the futures markets on the daily trade in physical coffee.
In recent years physical prices have largely been determined by applying a differential to prices in the futures market; that is, the combination of the differential plus or minus and the price of the selected futures position gives the price for the physical coffee.
The tables below demonstrate the huge growth in volume of the trade in options and futures: Annual turnover in futures compared with gross world imports millions of tons. Annual turnover in options and futures millions of tons. World coffee trade 1. The markets for coffee 2. Niche markets, environment and social aspects 3. Logistics and insurance 5. Farm to processing 5. W-house — processing 5. Transport to port 5. FCL or CY 5. E-Commerce - supply chain management 6.
Request for arbitration 7. Hearing, award, … 7. Costs and fees 7. Hedging and other operations 9. Risk and trade credit
United Futures Trading Company, Inc. Suite Chicago, IL This publication is the property of the National Futures Association. Return to table of contents. Anyone buying or selling futures contracts should clearly understand that any given transaction may result in a liquidity risk of futures trading. The loss may exceed not only the amount of the initial margin but also the entire amount deposited in the account or more.
Moreover, while there are a number of steps that can be taken in an effort to limit the size of possible losses, there can be no guarantees these steps will prove effective. Well-informed futures traders should be familiar with available risk management possibilities.
Choosing a Liquidity risk of futures trading Contract Just as different common stocks or different bonds may involve different degrees of probable risk and reward at a particular time, so may different futures contracts. The market for one commodity may, at present, be highly volatile, perhaps because of supply-demand uncertainties which—depending on future developments—could suddenly propel prices sharply higher or sharply lower.
The market for some other commodity may currently be less volatile, with greater likelihood that prices will fluctuate in a narrower range.
You should be able to evaluate and choose the futures contracts that appear—based on present information—most likely to meet your objectives, your willingness to accept risk and your expectations as to when the anticipated price change will occur. Keep in mind, however, that neither past nor present price behavior provides assurance of what will occur in the future.
Prices that have been relatively stable may become highly volatile which is why many individuals and firms choose to hedge against the possibility of future price changes. Liquidity There can be no ironclad assurance that, at all times, a liquid market will exist for offsetting a futures contract that you have previously bought or sold. This could be the case, if a futures price has increased or decreased by the maximum allowable daily limit and there is liquidity risk of futures trading one presently willing to buy the futures contract you want to sell or sell the futures contract you want to buy.
Even on a day-to-day basis, some contracts and some delivery months tend to be more actively traded and liquid than others. Two useful indicators of liquidity are the volume of trading and the open interest the number of open futures positions still remaining to be liquidated by an offsetting trade or satisfied by delivery.
These figures are usually reported in newspapers that carry futures quotations. The information is also available from your broker or advisor and from online market reporting services and exchange web sites. Stop Orders A liquidity risk of futures trading order is an order, placed with your broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Stop orders are often used by futures traders in an effort to limit the amount liquidity risk of futures trading might lose if the liquidity risk of futures trading price moves against their position.
If and when the market reaches whatever price you specify, a stop order becomes an order to execute the desired trade at the best price immediately obtainable. There can be no guarantee, however, that it will be possible under all market conditions to execute the order at the price specified.
In an active, volatile market, the market price may be declining or rising so rapidly that there is no opportunity to liquidate your position at the stop price you have designated. In addition, although it happens infrequently, it is possible that markets may be lock limit for more than one day, resulting in substantial losses to futures traders liquidity risk of futures trading may find it impossible to liquidate losing futures positions.
Subject to the kinds of limitations just discussed, stop orders can nonetheless provide a useful tool for the futures trader who seeks to limit his losses. Far more often than not, it will be possible for the broker to execute a stop order at or near liquidity risk of futures trading specified price.
In addition to providing a way to limit losses, stop orders can also be employed to protect profits. Spreads As previously discussed, spreads involve the purchase of one futures contract and the sale of a different futures contract in the hope of profiting from a widening or narrowing of the price difference.
Because gains and losses occur only as the result of a change in the price difference—rather than as a result of a change in the overall level of futures prices—spreads are often considered more conservative and less risky than having an outright long or short futures position.
In general, as long as you are trading the same number of futures contracts, this may be the case. It should be recognized, though, that the loss from a spread can be as great as—or even greater than—that which might be incurred by having an liquidity risk of futures trading futures position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures prices, and it is possible to experience losses on both of the futures contracts involved that is, on both legs of the spread.
Past performance is not necessarily indicative of future results. The risk of loss exists in futures and options trading. Past performance is not necessarily indicative of future results and the risk of loss does exist in futures trading. All trading rates quoted per side. Applicable exchange, regulatory, and brokerage fees apply to rates shown. Please email webmaster unitedfutures.
Open An Account Now Online! Understanding and Managing the Risks of Futures Trading. Return to table of contents Anyone buying or selling futures contracts should clearly understand that any given transaction may result in a loss.
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