How the Futures Market Can Help You Mitigate Risk
The futures exchange can be surprising. While some investors use this market to make real money, it isn’t a vehicle for the faint of heart or unsophisticated. Anyone short of informed, highly engaged investors can take enormous losses, so when it comes to individual portfolios most professionals give the same advice about investing in futures: don’t.
At the same time the futures market serves another purpose. It can play a major role in mitigating risk across many sectors of the economy.
Investors in futures buy a contract against future prices, purchasing now and making money if prices go up. They can choose one of two kinds of investments: either commodities or financial products. For example, a commodity trader who purchases coffee bean futures will literally be buying an amount of coffee beans; if the price of Arabica goes up, those beans become more valuable and the investor makes money. (This is an actual purchase. Investors who don’t trade off their contract will receive delivery.)
“A futures contract,” said Lance Mitchell, director of research for First Franklin Financial Products, “is a contract to purchase some asset into the future, on a specific date, typically at a specific price. That could be almost anything from commodities to the VIX, which is a volatility measure on the overall stock market.” Critically in this market, short selling is commonplace. This allows investors to trade on the volatility of commodity prices, betting not just that oil will be more expensive next week but that it might instead be cheaper.
The same goes for financial products. A marketplace which trades on future value can, and does, include just about everything. So, for example, a trader could agree to purchase a bundle of variable rate debt on the belief that interest rates will go up. Another could try to short mortgages if he foresaw another housing collapse, or oranges in advance of hurricane season.
This, along with the ability to trade financial products, is a critical aspect to using commodities to level out risk.
It hurts less to pay higher fuel prices, after all, when you already own some of it.
“They’ve had mixed results,” Mitchell said. “A lot of them are finding out that it’s not worth it for them to hire a firm and the firm just doesn’t do a good enough job.”
Not to mention, in mitigating the risk of higher commodities, the money a company has to invest means that it sees less return when the price of that product drops. As a result, few try this. The airlines continue to, according to Mitchell, as do companies which stand to lose a lot of money in currency fluctuations.
Someone hoping that McDonald’s stock will soar in the wake of lower beef prices will inevitably end up disappointed. Instead that investor can buy directly into beef, assuming all of the risks of commodity pricing but leveling out the risks of McDonald’s getting its business model wrong on the way to profit.
“A lot of people think, ‘If I want to invest in gold I’ll just invest in a gold mine,'” Mitchell said, “‘Or if I want oil and gas, I’ll invest in an oil and gas producer,’ but it doesn’t always work that cleanly.”
“[The futures market] is the best way to invest in the price of a commodity without having all of the associated business risks that come with owning a stock from a company that does something having to do with that commodity,” he added.
While it’s rare for investors to want that degree of certainty, those that are looking for direct returns on supply-line changes can get it through the futures market without taking on the risks of mismanagement.
Finally, financial futures allow investors to hedge against the financial markets themselves.
While there are many ways to do this, one of the most common is the VIX. Based on numbers from the Chicago Board Options Exchange, this is a measure of how much the CBOE expects major price swings in the financial markets. It works in both directions; high volatility can be as much the measure of a bullish (strong) market as a bearish (weak) one.
For investors looking to hedge their bets, the real key to betting on volatility is if the market goes bad.
As Mitchell put it, it allows investors to build diversity into their portfolios, creating value based on something other than stock market prices.
“A lot of people will use the VIX as a quick hedge against volatility in the stock market as their portfolios begin to fall,” he said. “You gain extra diversification that a normal investor would have a hard time getting if they didn’t use the futures market.”
Like a company hedging against its increased costs of production, the VIX isn’t a silver bullet for weak portfolios. Used properly, however, sophisticated investors can use it to plan against risk or react quickly, betting on future market turmoil as a way to recoup some of the losses they’re feeling elsewhere.
Ultimately when it comes to hedging risk through futures, this diversification is the key factor. The futures exchange allows investors to access a different section of the market, one driven by prices and value rather than the outcome-based rates of the stock market. While the rules of this market are more cutthroat, and unsophisticated investors can lose their shirts quickly, it’s also an opportunity to smooth out liabilities in a business model.
Many firms do.