Risks and Returns: Understanding Futures Market Volatility

How does leverage amplify gains and losses?

Whether market prices rise or fall, investors have the opportunity to profit from any market fluctuations in futures trading. They can go long or short, depending on how they think the market will move. (Learn more about going long and short in this article. They can also hedge current investments in their portfolio.

But because futures are leveraged, investors may gain amplified gains, and if the market does not move their way, investors may also face amplified losses.

High-yield potential

Futures are margin, which means investors only need to invest a small portion of the contract value to open a position. In short, margins convey the ability to control larger positions than non-margin instruments. This is a key feature that makes futures an attractive option for investors who can take on more risk.

For example, suppose an investor wants to trade nano ether futures. The contract size is 1/10 of Ethereum. The price of Ethereum is US$4,000, and the nominal value of the contract is:

0.1x4,000=$400 0.1x4,000= US$400

Since futures use leverage, investors only need to invest a small portion of the contract value, called margin. If the margin is 30%, they only need to deposit $120, or 30% of the nominal value of $400.

As a result, investors control contracts worth $400 for $120.

If the price of Ethereum rose 10% from $4,000 to $4,500, the new value of the contract would be:

0.1x4,500=$450 0.1x4,500 =$450

Investors would gain $50 because their original contract was worth $400. With an initial margin of $120 and a profit of $50, investors will see an initial return on investment of 41.67%, even though the price of Ethereum has increased by only 12.5%.

can cause significant losses

But just as leverage can increase gains, it can also amplify losses. If investors open long positions in nano Ethereum futures, they will still be responsible for larger positions in margin control.

For example, if the price of Ethereum fell from US$4,000 to US$3,500, the new value of the contract would be:

.1x3,500=$350. 1x3, 500 = US$350

Since the original notional value of the contract was US$400, investors would lose US$50 on the US$120 initial margin. Therefore, even if the price of Ethereum fell by only 12.5%, investors would still lose 41.67% of their initial investment.

Market Volatility

Some futures markets, especially assets such as cryptocurrencies, may experience abnormal fluctuations. Sudden price fluctuations bring both huge opportunities and risks.

For example, in 2021, Bitcoin experienced several large price fluctuations. In April, it hit a record high of $64,895. By July, it had fallen 50% to $30,829, but hit another all-time high of $69,000 in November. The price of Bitcoin fluctuated significantly, even falling by 30% in one day. Now, Bitcoin transaction volume exceeds $100,000.

The key is that the market can turn quickly. Although futures are a convenient way to participate in the market, there is no guarantee that investors will make a profit. It is important for investors to be aware of the risks associated with the underlying assets of the contracts they invest in.

Risk Management Strategies

Investors need to know how much risk they can take in any market. There are several common strategies investors can consider when considering starting to participate in the market.

One strategy to minimize risk is to develop and adhere to a trading plan. Although a plan does not guarantee that the market will move in a direction that is beneficial to investors, it can help investors make strategic transactions. This means studying, weighing pros and cons, and proactively trading with a clear ultimate goal.

Through the plan, investors can avoid making reactive or emotional decisions, which may cause more risks and losses.

One way to manage risk is to trade smaller contracts designed specifically for retail investors, such as the Coinbase Nanofutures Contract Suite. Although these investments still carry risks, investors have not invested as much money as they did when buying large contracts.

These smaller contracts allow retail investors to participate in the market with lower capital, reducing risk exposure while still providing profit opportunities.

Review

Key Terms

Leverage

The ability to control large positions with relatively little capital or initial margin through margin futures. Leverage provides traders with significant exposure to the underlying asset without having to pay the full value of the contract in advance.

Margin

Deposit required to open a position in a futures contract. Typically, margin is a small portion of the nominal value of the contract.

exposes

the extent to which investors are affected by changes in the value of the underlying asset under the contract. Essentially, risk exposure represents the amount of risk or potential profit or loss that a trader may face due to market fluctuations.

It is important that everyone consider their own risks before considering investing in any market. Although futures markets have particularly relatively low barriers to entry, investors are still exposed to potentially volatile markets, which can lead to losses.