This statement is meant to act as a basic outline of the risks involved in the trading of futures, foreign exchange, and options. It does not divulge all of the risks and other significant aspects involved in the trading of these financial assets. You should trade in these products only when you fully understand the nature of the contracts, the obligations of each party, and the level of your exposure to risk. Many members of the public are not well equipped to trade in derivatives. Before deciding on whether to trade, it is important that you evaluate the appropriateness of trading in light of your, goals, skills, experience, financial resources and expectations, among others.
FUTURES AND FOREX
1. RISK-REDUCING TACTICS AND STRATEGIES
2. EFFECT OF "LEVERAGE" ON RISK
Futures and Forex transactions usually require one to deposit a fraction of the value of the contract as capital commitment; hence, the transactions are leveraged/geared. The capital commitment (margin) allows one to enjoy the full returns just as one who has deposited the whole value of the contract. This makes it very cheap for traders to speculate hence making these transactions to be extremely risky. A small change in the market may have a very large impact on the margin. At the end of the day, this may work for you or against you depending on the direction of the change. If it happens that the market moves against your position, or margin levels are increased, you may be requested to make additional deposits on short notice so as to maintain your position. Failure to comply with this request within the required time may cause your position to be liquidated, and you will be liable for any deficit that may arise thereafter.
3. OPTION RISKS
Like trading in futures and Forex, trading in options is a risky undertaking. Traders who are not well versed with option contracts face an even greater exposure. Understanding the following will help you in bringing down your exposure:
Ø The type of option you intend to trade in; whether it is a put option or it is a call option.
Ø The level of risk that you will face because of trading in that option. You need to know what your rights and obligations are
Ø The direction to which and extent by which the option’s value must change for you to make a profit. In determining this, you must take into account the premium and the transaction costs.
Since the options contract does not impose an obligation on the buyer to exercise the option, the buyer is at liberty to let it expire.
When the buyer chooses to exercise the option, the result may be a cash settlement or a transfer of ownership of the underlying asset as specified in the contract. If the buyer chooses to let the option expire worthless, he or she will suffer a total loss of the investment, which includes the transaction costs and the premium.
If the option is on a future, the buyer will acquire a futures position with associated margin liabilities.
It is critical to note that Deep out-of-the-money options are rarely profitable.
Selling (also referred to as “writing” or “granting”) an option, is generally riskier than buying one. Although the seller receives a fixed premium, he or she may sustain a loss far much more than this. In case the market moves against the seller, he or she will be liable for the additional margin needed to maintain the existing position
The risk that the seller faces is that the buyer may choose to exercise the option and hence the seller will be required to either settle the option in cash, or facilitate the transfer of the underlying interest as per the contract.
In order to reduce the level of risk involved, the seller may choose to cover his or her position by holding a corresponding position in the underlying interest, or a future, or another option; otherwise, the risk of loss can be unlimited.
Certain exchanges allow the buyer to defer the payment for the option, hence exposing him or her to liability for margin payments, which does not exceed the premium amount.
OTHER COMMON RISKS ASSOCIATED WITH FUTURES, OPTIONS AND FOREX
4. TERMS AND CONDITIONS OF CONTRACTS
Before you trade in any of the above, the terms and conditions of the contract must be very clear in your mind. Ask the firm you are dealing with for the specific terms and conditions of the contract. You must know how you will benefit and what your obligations will be. You also need to know the special conditions, for example, under what circumstances may you become obligated to make or take delivery of the underlying interest of a futures or forex contract? What are the expiration dates and restrictions on the time for exercise of options contracts? Certain circumstances may cause the exchange or clearinghouse to adjust the specifications such as the exercise price of an option, in order to reflect the changes in the underlying interest.
5. UNFAVORABLE MARKET CONDITIONS AND RULES
Certain market conditions or rules increase the chances of loss. Market conditions such as illiquidity, and unfavorable market rules such as those that require the suspension of trading in contracts because of price limits, make it impossible to effect transactions that may assist in reducing exposure to risk.
It is important to note that there may be a lack of an existing normal pricing relationship between the underlying interest and the future, and the underlying interest and the option. This usually occurs when the futures or the forex contract underlying the option is subject to price limits, while the option itself is not. Judging the fair value of the contract when there is a lack of an underlying reference price becomes complicated.
The buyer still faces the risk of losing the premium and transaction costs, but nothing more. In cases where the option is exercised or is left to expire, the buyer will be liable for any outstanding premium.
6. DEPOSITED CASH AND PROPERTY
7. COMMISSION AND OTHER CHARGES
8. TRADING IN FOREIGN JURISDICTIONS
It is imperative to note that in case of a dispute, your local regulatory authority may not be in a position to influence the regulatory authorities or markets in other jurisdictions where your transactions have been effected, in order to protect your investment. Before you start trading, make sure that you have adequate knowledge about the types of redress options available in both your home and other jurisdiction.
9. CURRENCY RISKS
10. TRADING FACILITIES AND ASSOCIATED RISKS
Just like any other system, trading systems are susceptible to temporary interruption or failure. Whether or not you will recover any losses you may suffer because of this is dependant on the liability imposed by the system provider, the market, the clearinghouse, member firms, and the relevant legislation. It is therefore very important that you know what you can recover, even before you start trading.
11. ELECTRONIC TRADING
12. OFF-EXCHANGE TRANSACTIONS
13. HYPOTHETICAL TRADING RESULTS AND THEIR LIMITATIONS
Ø Hypothetical performance results are generally prepared with the benefit of hindsight, which is not applicable in real life trading.
Ø Hypothetical trading ignores financial risk that arises as a result of leverage.
Ø Specific market rules and conditions that affect the level of risks are ignored.
The above factors together with many others, can adversely affect the actual trading results. No matter how good a trading program is, it cannot fully account for the many factors that can adversely affect actual trading results, yet are not considered in the preparation of hypothetical results.