Risk and reward: Understanding futures market volatility

Whether prices in the market rise or fall, investors have the opportunity to potentially profit from any market fluctuation in futures trading. They can go long or short, depending on how they believe 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 have leverage, investors have exposure to magnified gains—as well as magnified losses if the market doesn’t move their way.

Futures are margined, meaning that investors only have to put down a fraction of the value of the contract in order to open a position. In short, margin conveys the ability to control a larger position compared to a non-margined instrument. This is a key characteristic that makes futures an attractive option for investors capable of taking on more risk.

 For example, let’s say an investor wants to trade nano Ether futures. The contract size is 1/10th Ether. With Ether priced at $4,000, the notional value of the contract is:

0.1x4,000=$400

Since futures use leverage, the investor is only required to put down a fraction of the contract’s value, called the margin. If the margin is 30%, they only need to deposit $120, which is 30% of the notional value of $400.

So, with $120, the investor controls a contract worth $400.

If the price of Ether rises by 10%, from $4,000 to $4,500, the new value of the contract would be:

0.1x4,500=$450

The investor would profit $50, since their original contract was worth $400. With the initial margin of $120 and the $50 profit, the investor would see a 41.67% return on their initial investment, even though the price of Ether only rose by 12.5%.

But just as leverage can boost gains, it can also magnify losses. If an investor opens a long position in nano Ether futures, they’re still responsible for the larger position that the margin controls.

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

.1x3,500=$350

Since the original notional value of the contract was $400, the investor would lose $50 on their initial margin of $120. So, even though Ether’s price only dropped by 12.5%, the investor would see a 41.67% loss on their initial investment.

Some futures markets, particularly assets like cryptocurrencies, can be exceptionally volatile. Sudden price swings create both considerable opportunities and risks. 

In 2021, for example, Bitcoin experienced several large price swings. In April, it reached an all-time high of $64,895. By July, it had fallen 50% at $30,829, only to reach another all-time high of $69,000 in November. Prices swung wildly for Bitcoin, even dropping as much as 30% in a single day. Now, Bitcoin trades over 100,000.

The point is that markets can turn fast. Though futures are an accessible way to participate in the market, there are no guarantees that investors will make a profit. It’s important for investors to be mindful of risks associated with the underlying assets of the contracts they’re investing in. 

It’s up to investors to know how much they can afford to risk in any market. There are a couple of common strategies that investors can consider as they think about starting to participate in the market.

Creating a trading plan

One strategy to minimize risk is to create and stick to a trading plan. While a plan can’t guarantee that the market will move in an investor’s favor, it can help investors to trade strategically. This means researching, weighing pros and cons, trading proactively with a clearly defined end goal. 

With a plan, investors can avoid making reactive or emotional decisions, which can potentially create more risk and losses.

Avoiding overleveraging

One way to manage risk is by trading smaller-sized contracts designed for retail investors like the Coinbase suite of nanofutures contracts. While there is still risk associated with these investments, investors aren’t putting down as much capital as they might be with larger contracts.

These smaller contracts allow retail investors to participate in the market with lower capital, reducing exposure while still offering opportunities for gain. 

Key terms

Leverage

The ability, via margined futures, to control a large position with a relatively small amount of capital, or initial margin. Leverage provides traders significant exposure to an underlying asset without needing to pay the full value of the contract up front.

Margin

The deposit required to open a position in a futures contract. Typically, the margin is a fraction of the contract’s notional value.

Exposure

The degree to which an investor is affected by changes in the value of a contract’s underlying asset. Essentially, exposure represents the amount of risk—or potential profit or loss—that a trader could face due to market fluctuations.

It’s important that each person considers their own risks before they consider investing in any market. While the futures market in particular offers a relatively low barrier to entry, investors still gain exposure to potentially volatile markets, which can result in losses.