Question

what are the main riskis associated with trading derivatves ?

Answer 1

The main risks associated with trading derivatives are Leverage risk and Commodity risk

1. Leverage risk

Derivative invstruments are highly leveraged. One can take position in the derivaties by putting only a fraction of the contract value. If the underlying changes only by a few percent, then thre will be a significant change in the position. This is called leverage risk.

Example: Let's say the underlying value of an asset is $2000 and the contract size is 100 units. The notional value of one contract = 2,000 * 100 = $200,000

Let's say margin required to buy one futures contract is 10%. That is 200,000 * 0.10 = $20,000.

A person with $100,000 in trading account can purchase 100,000/20,000 = 5 contracts.

The notional value of 5 contracts = 200,000 * 5 = 1,000,000.

If the underlying asset drops by 10%, then the loss = 1,000,000 * 0.10 = $100,000

So, the entire account is wiped out.

2. Commodity risk

When one enters a futures contract in commodity, then the trader is obligated to either take the delivery or sell the underlying asset.

Let's a trader is long one futures contract on crude oil. On the expiration date, the trader must take delivery of crude oil.

Because of no demand in crude oil and over supply of oil, the price of oil starts to go down. The trader who is long crude oil starts to lose money. As there is no demand, and there is storage cost if the delivery is taken, no one is interested in taking delivery. So, the price drops to zero and into negative. Meaning the buyer of the crude oil gets paid to take delivery or the seller must pay to give delivery. This is a huge risk for the long futures commodity trader.

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