What is Risk?
Risk is something that traders will be managing for the entirety of their trading career. One way that we can define risk is by saying that it is exposure to mischance. In investment terms, risk is the possibility that you can lose money in any particular trade.
One thing to point out here is that the possibility of losing money is always higher when you are trying to get a greater return on your investment (ROI). A big ROI is exactly what speculators are attempting to do.
Risk-Free Rate
At some point, you are going to come across something called the “risk-free rate” so we will take a moment to look at what that is. The risk-free rate is the interest rate on a US treasury. A US treasury is considered by the markets to be free from risk. So if you buy a US Treasury you should expect to get your money back at some point. Because it is free from risk is exactly why a treasury pays almost nothing in terms of interest. The price of US treasuries changes over time but almost certainly they will not pay more than the current rate of inflation. In fact, inflation is almost always higher than the interest rate of a US treasury.
Anything that pays a higher rate of return than the US treasury is said to have higher levels of risk. The higher the percentage yield you get, the higher the level of potential risk involved in that asset or investment. Ask yourself this: Who is more likely to NOT pay their bills, the US government or your brother-in-law that has borrowed money from you to start up a new local restaurant? Obviously, your brother-in-law is the riskier choice because the outcome of his venture is far more uncertain than if the United States is going to pay you their debt obligations.
Two Tpyes of Risk
There are two types of risk:
- Specific Risk: This is the kind of risk that is specific to an individual or particular investment.
- Non-Specific Risk: This is the risk present in all portfolios of investments. It is most widely classed as general market risks and cannot be removed no matter what the situation is. The fact is there will always be varying degrees of risk in every investment.
Futures and Risk
The primary use of futures is that they can be used to diversify away from risks as much as possible in an efficient manner. Futures also have much lower transaction costs than re-balancing an entire portfolio which for large funds can be a lot of unwinding with heavy costs involved. For example, in the Forex markets currency risk can be hedged with currency futures. In the stock market, portfolios of stocks can be hedged with the appropriate index futures as well.
Futures were one of the first methods used in the concept of risk management which is why they are so popular and important to all modern markets.
Leverage
While we are on the topic of risk it is important to point out another primary feature of many different markets such as Forex, futures contracts, cryptocurrencies, etc. This is, of course, the high leverage that traders have access to. For a small deposit, known as margin, a trader can control a significantly larger valued position than the money they have in their trading account. Measured as a percentage of the money you have invested, the profit or loss potential on a leveraged product is much larger than a similar investment in the actual underlying asset itself.
Using leverage can significantly increase the potential percentage returns but it also works in reverse. This means that it can significantly increase your losses if you are wrong about a specific trade.
Leverage Example
As an example of leverage in futures contracts, holding a representative basket of the stocks in the FTSE 100 index that is currently trading at a price of 5450 would require holding physical stock at a cost of £54,500. To hold one FTSE futures contract might require an initial margin deposit of just £3,000 which is obviously a lot smaller. A 5% gain in the price of the FTSE would give the holder of the futures contract a gain of £2,725. The percentage return for the holder of the contract, however, is significantly different from that of the FTSE index. The shareholder holding the basket of stocks has a 5% return on capital invested while the trader of a futures contract has a 90% return. Of course, this works the same for losses as well and the trader could have had a 90% loss while the investor had only a 5% loss. It really works both ways.
Leverage will always magnify any gains or losses and should be treated with full respect.