Question

A futures market is a central financial exchange where people can trade standardized futures contracts. A futures exchange provides physical or electronic trading venues, which can be organized as non-profit member-owned organizations or for-profit organizations. Futures exchanges can also be integrated under other types of exchanges, such as stock markets, options markets and bond markets. Futures contracts are sometimes used by corporations and investors as a hedging strategy. Hedging refers to a range of investment strategies that are meant to decrease the risk experienced by investors and corporations. Questions; The futures market is referred to as an auction market, whereby producers and suppliers of commodities endeavour to avoid market volatility; in other words, producers and suppliers negotiate contracts with an investor who agrees to take on probable risk and reward, based on the expected volatility of the market.

1. Critically discuss the theoretical concept of futures contracts as a risk management tool, used by any would be investor to decrease future risk exposure or market volatility.

2. Review and discuss the collapse of the Futures Oil Market, which fell into the negative realm in May 2020.

What were the main reasons for this fall into the negative realm? Critically discuss. Total 35 marks

Answer 1

Answer1.

A ifutures imarket iis ian iauction imarket iin iwhich iparticipants ibuy iand isell icommodity iand ifutures icontracts ifor idelivery ion ia ispecified ifuture idate. iFutures iare iexchange-traded iderivatives icontracts ithat ilock iin ifuture idelivery iof ia icommodity ior isecurity iat ia iprice iset itoday.

A ifutures icontract iis ia ilegal iagreement ito ibuy ior isell ia iparticular icommodity iasset, ior isecurity iat ia ipredetermined iprice iat ia ispecified itime iin ithe ifuture. iFutures icontracts iare istandardized ifor iquality iand iquantity ito ifacilitate itrading ion ia ifutures iexchange. iThe ibuyer iof ia ifutures icontract iis itaking ion ithe iobligation ito ibuy iand ireceive ithe iunderlying iasset iwhen ithe ifutures icontract iexpires. iThe iseller iof ithe ifutures icontract iis itaking ion ithe iobligation ito iprovide iand ideliver ithe iunderlying iasset iat ithe iexpiration idate.

Futures iare iderivative ifinancial icontracts ithat iobligate ithe iparties ito itransact ian iasset iat ia ipredetermined ifuture idate iand iprice. iHere, ithe ibuyer imust ipurchase ior ithe iseller imust isell ithe iunderlying iasset iat ithe iset iprice, iregardless iof ithe icurrent imarket iprice iat ithe iexpiration idate.

Underlying iassets iinclude iphysical icommodities ior iother ifinancial iinstruments. iFutures icontracts idetail ithe iquantity iof ithe iunderlying iasset iand iare istandardized ito ifacilitate itrading ion ia ifutures iexchange. iFutures ican ibe iused ifor ihedging ior itrade ispeculation.

Risk imanagement iwhen itrading ifutures ishares imany iof ithe isame ifeatures ias ithat iof istocks i- ifor iinstance, ifutures itraders iare iexposed ito iprice irisk iin ithe imarket. iBut, iunlike istocks, ifutures iare iderivatives icontracts iwith iset iexpiration idates ithat irequire ithe idelivery iof ithe iunderlying iasset. iFutures iare ialso imuch ifriendlier ito ithe iuse iof ileverage ion imargin ithat ican iamplify iboth igains iand ilosses.

· Futures icontracts iare ipopular ifinancial iinstruments, ibut ithey idiffer iin iimportant iways ifrom imore itraditional iassets ilike istocks ior ibonds, iand iso iyour irisk imanagement iwill ialso idiffer.

· Futures iare ihighly imarginable, iso iyou ican iincrease iyour ileverage ifar imore ithan iwhen ibuying istocks.

· This ican ilead ito imargin icalls iif iyou're inot icareful iabout isetting istops.

Risk imanagement iis isometimes ian ioverlooked iand imisunderstood iarea iof itrading. iIt ican isound iboring icompared ito ia idiscussion iof istochastic ipatterns, iFibonacci isequences, iand iother imatters iof itechnical ianalysis. iHowever, iit iis icritical ito iany isuccessful itrading iplan.

Even ia itrading istrategy ias isimple ias ia imoving iaverage icrossover isystem ican ibe iruinous iif iproper irisk imanagement iis inot iapplied. iThis idiscussion iof irisk imanagement iwill ihelp iyou ibuild ia ifoundation iof iconcepts iyou ican iapply ito iany itrading iplan.

A irisk iand imoney imanagement iplan iwill ihelp iyou iin ianother ikey iarea—discipline. iMany iinvestors idon't ihesitate ito ienter ia itrade, ibut isometimes ihave ilittle iidea iof iwhat ito ido inext iand iwhen. iHaving ia iplan iin iplace iwill ikeep iyou idisciplined iand iprevent ithe iemotions ilike ifear iand igreed ifrom itaking iover iand icausing iyou ito iexperience ifailure.

A igood iplace ito istart iis iwith ithe iconcept iof irisk icontrol. iTraders iare iattracted ito ifutures ibecause iof ithe ileverage ithat iis iprovided—vast isums ican ibe iwon ion ivery ilittle iinvested icapital. iHowever, ithe icost iof ithat ileverage iis ithe ifact ithat iyou ican ilose imore ithan ithe ibalance iof iyour iaccount. iSo, ihow ican iyou icontrol ithat irisk?

First, iconsider ithat ithe irules iregarding imargin iare iabout iminimums. iThere iare ino irules ithat iaffect ithe imaximum imargin iyou ican iapply ito ia itrade. iIn iother iwords, iif iyou iare iconcerned iwith ithe ileverage iof ipotential ilosses iof ia imarket, iapply imore icapital. iTrue, iyou iwill ibe ireducing iyour ioverall ireturn, ibut ithis ialso ibrings ieverything iinto ibalance. iOn ithe iother ihand, ihighly ileveraged ipositions ican iquickly ilead ito imargin icalls iif ithe ifutures imarket iturns ieven islightly iagainst iyou iin ishort iorder.

Below iwe ilist ifive ikey iaspects iof ifutures itrading irisk imanagement ito ihelp iyou iadjust ito imarket iuncertainty.

1. Distinguish iBetween iHigh iand iLow iQuality iTrade iSetups

It iisn’t iuncommon ito ifeel inervous iwhen ientering ia itrade. iBut iyou ishouldn’t idoubt iit ieither, ithat iis, iif iyou idid ithings iright i(measure iyour isetup, icalculate iyour irisks, ietc.). iIt idoesn’t imean ithat iyou iare i100% iconfident iyour itrade iwill iwork iout ias iplanned. iIt’s imore ilike iyou’re i100% iconfident ithat iyou iknow iwhat ito ido iif iit idoesn’t.

One iof ithe imost iimportant iways ito isettle idoubts iin iyour imind iwhen iexecuting ia itrade iis ito iclearly iidentify iand ichoose ibetween ivarying itrading isetups iin iterms iof iquality. iPick ithe ibest isetup, imake isure iyou iunderstand iit icompletely i(e.g. irisk/reward, iprofit, iand itermination ipoints), iand iexecute iit. iIn ithe iend, iit’s ireally ithe ibest iyou ican ido. iBut inote ithat imany itraders ican’t ieven iget ithis ifar.

Whatever iset iof itriggers iyou iuse ito idecide iyour imarket ientries, iyou ineed iclear-cut irules ito idistinguish ibetween ihigh-quality iand ilow-quality isetups, iwhich ican ieither ibe itoo irisky i(low ireturn-to-risk isetups) ior iwhose iconditions ior ipotential ipayoffs iare itoo iobscure. iIn iother iwords, iyou ineed ito iknow ihow ito ifilter itrades ibased ion irisk iand ireward.

This, iof icourse, iis imuch ieasier isaid ithan idone. iIt imight itake ia iconsiderable iamount iof iiterations, itesting, iand itweaks ito iget iyour itrading imethod ito iyour idesired ilevel iof iobjectivity iand ieffectiveness. iBut iit’s iworth iit. iKnowing iwhether iyou iare ientering ia ipotentially ihigh iprobability itrade isetup iversus ia ilow iprobability itrade isetup ican ihelp iyou igo ia ilong iway iin iterms iof ipreparation iand idealing iwith ilive-scenario ioutcomes.

2. Plan iOut iContingencies

If iyou ihaven’t iplanned ialternate isolutions ito ipotential icontingencies, ithen iyou imay ifind iyourself istruggling iwhen iunexpected imarket imovements itake iplace.

Often, isimply irelying ion ihigh-quality itrade isetups imay inot ibe ienough ito iescape ithe iperils iof iunexpected iprice imovements. iAs iwe imentioned iat ithe ibeginning iof ithis iarticle, ithere iis ino iproven iway ito iensure iaccurate iprice ipredictions iand ias isuch, ino ilevel iof itrade isetup iquality ican iever iinsure iyou iagainst ithe ilikelihood iof ian iuncanny iprice imove iderailing iyour itrade.

3. Stay iAway ifrom iRigid iTrading iPlans

New itraders ioften iintuitively ifall iback ion irigid iand iinflexible itrading iplans ito ieliminate iall iguesswork iand imental istrain iarising ifrom imaking iad ihoc itrading idecisions. iBad imove. iAs icounterintuitive ias iit imay isound, ileaving isome ilevel iof isubjectivity iand ivariance iin iyour itrading iplan iis iessential ito ia iwell-rounded iand icompetent itrading istyle.

The ipoint ihere iis ito ibe iable ito ifind ithe iperfect ibalance ibetween ithe iobjective iaspects iof imaking itrading idecisions i(classifying itrade isetups, imarking iout iclear-cut itrouble iareas ifor iprice) iand ithe isubjective iaspects i(some iflexibility iin itrade imanagement) iresulting ifrom ivariance iin imarket iconditions.

4. Let ithe iNumbers iPlay iOut

This imight ibe ione iof ithe imost iimportant ifactors ito iconsider iwhile itrying ito ideal iwith ithe iambiguity iprevalent iin iyour iday ito iday itrading. iCumulative itrading iresults ihardly iever ihinge ion ia isingle itrade ior, ifor ithat imatter, ieven ia ismall igroup iof itrades.

If iyou itruly ihave ia itrading iedge, iit ican ionly ibe iconfirmed iover ia iwide isample isize iof itrades. iYour ilast itrade idoesn’t ireally icount, iso idon’t ifall ivictim ito ithe itendencies iof i“recency ibias.” iYou imust itake iinto iaccount iall iof iyour itrades, iand ithis idevelops iand ichanges iwith ieach iand ievery isubsequent itrade iyou imake. iAnalyzing iyour ipast itrades ican ialso iprovide ivaluable iinsights iinto ihow iyou ican iimprove iyour isystem iand iincrease ithe iasymmetric irisk iand ireturn iratio.

5. Practice iMakes iPerfect

Everything iwe’ve idiscussed iso ifar iconnects iwith ithe inumber iof ihours ispent ibehind iyour icomputer iscreen. iIt’s iabout ipractice. iAnd iwe’re inot italking iabout i“demo” ipractice. iThat ishould ibe ileft ibehind ias isoon ias ipossible ias iit idoesn’t icome iclose ito ithe ilive imarket.

Planning iout iall icontingencies irequires ian ialert imind ithat iis iopen ito ivarious iangles iof ichart ianalysis i– ia iskill ithat igets ibetter iwith itime iand ipractice. iFinding ithe iright itrading imethod ithat iclearly idifferentiates ibetween igood iand ibad iquality itrades ialso itakes itime ito idevelop. iAs ithere iis ino ione-size-fits-all itrading imethod iout ithere ithat iguarantees isuccess, iany iworkable imethod iwill iusually iinvolve iiterative iand icorrective iprocesses ito irefine iit ito isuit iyour iunique itrading ipersonality iand istyle.

Answer2.

Crude ioil ifutures iare icontracts iwhere ibuyers iand isellers iof ioil iagree ito ideliver ia ispecific iquantity iof icrude ioil ion ia igiven idate iin ithe ifuture iat ia ispecific iprice. iIn ioil ifutures ione icontract irepresents i1,000 ibarrels iof icrude ioil iand ian ioil ifuture icontract ican ibe iclosed ieither iby iphysically itaking idelivery iof ithe ioil ior iby isettling ithe icontract iby iselling iit ito ianother ibuyer iin iexchange ifor imoney. i

Each iregion ihas ia idifferent imarker ifor iits itraded icrude ioil, ifor iexample iWest iTexas iIntermediate i(WTI), itraded ion ithe iNynex iexchange igives ian iindication iof ithe iprice iof icrude ioil iproduced ifrom iUS ioil ifields, iwhile iBrent icrude ioil itraded ion iIntercontinental iExchange i(ICE), iLondon, igives ian iindication iof ithe iprice iof icrude ioil iproduced ifrom ithe iNorth iSea, iAtlantic iOcean.

Brent icrude iprice imarker iis iconsidered ia iglobal ibenchmark, ias inearly itwo-thirds iof ithe iworld’s ioil iis itraded ibased ion iBrent icrude iprices.

A ifutures icontract ifor iU.S. icrude iprices idropped imore ithan i100% iand iturned inegative ifor ithe ifirst itime iin ihistory ion iMonday, ishowing ijust ihow imuch