Single-Stock Futures Part 10

Basis Risk

In the last course, we learned about the basic risks and rewards of futures contracts. We're now going to focus on a specific type of risk that is probably the biggest risk that hedgers face.

We say it is the biggest risk because the size of the risk is unknown. With the other risks we presented, we can measure their effects and take necessary precautions. For example, if you are afraid of the leverage in futures, you can simply buy fewer contracts. We know how much leverage they provide and that does not change. If you are afraid of maintenance calls, you can keep some cash on the side or even deposit the full contract value to your account. We know at which points those would occur and how much you would need to deposit. There is usually some way to either reduce or control all the other types of risk we talked about.

However, there is a risk that you cannot circumvent for the very reason that you cannot measure it. It is called basis risk. Basis risk arises from the basis, which is just another word for the spread that we said was the difference between the futures price and spot price. ^[1] We also said that the spread would shrink as expiration nears, since the futures price must converge to the spot price. However, the rate at which the two prices converge prior to expiration can vary; the uncertainty associated with it is called basis risk.

Basisrisk is often associated as a risk for hedgers, but is a significant risk for speculators as well. For example, say the S&P 500 index is at 1000 and you are long a three-month S&P futures contract at 1010. At this point, the spread, or basis, is 10 -- the futures price minus the spot price. We know at expiration the basis will be zero since the futures price and spot price must be the same. But let's say you get out of the contract early with the spot index at 1015. You should be up five points from your purchase price of 1010. However, because futures and spot markets are different, they are subject to their own sets of supply and demand. You may go to close the contract and find it is trading for 1012. If so, your expected five-point profit has been reduced to two points -- that's basis risk.

Basis risk is a real problem for hedgers. Imagine the car dealer in the first week who bought futures on the Japanese yen to lock in a purchase price for the cars. If his payment is due before the contract expires, those futures contracts may not provide a full hedge and he could still end up with a loss. This problem is compounded by the fact that futures contracts will rarely expire on the exact day you need them to, which leaves you exposed to basis risk. Let's take a look at some specific examples of basis risk.

Example 1: Basis Risk of a Short Hedge

If you recall that car dealer example, we assumed a Lexus dealer had to purchase 125,000,000 Japanese yen in three months. Let's continue with that example and understand that the Japanese manufacturer, Lexus, will be receiving that many yenin three months. Lexus will also likely wish to hedgethat cash inflow. Their concern is that the value of the yen may fall between now and then, so hopefully you know they will need a short hedge -- they must sell the Japanese yen contract.

In our original example, we assumed the car dealer would take delivery in three months and that he also bought a matching three-month contract. But let's add a twist this time. Let's say the delivery will be made in two months and the Japanese firm will take delivery of Japanese yenat that time, but it sells a three-month contract to hedge. Why would Lexus sell a three-month contract? Because a two-month contract may not exist. Remember, futures are standardized contracts as to size and time, so you don't always get the perfect choice.

The Japanese manufacturer wishes to protect the entire 125,000,000 yenit will receive, so it will need to sell 10 contracts, which we'll assume are sold for 7850. This means it is expecting to receive 125,000,000 yen from the car dealer in two months at a price of $.007850, a value of $981,250. The important point in understanding basis risk is this: If the value of the yen is down in two months, Lexus is expecting to profit from the gain in the futures contract to offset that loss.

Two months go by and the yen is, in fact, down and trading for 7800. However, the contract, which has not expired yet, is trading for 7820. Remember, at expiration, the futures price will converge to the spot price. But prior to expiration, the two will not be trading for the same value. Lexus takes delivery of the 125,000,000 yen, which is worth $975,000 rather than the $981,250 it was expecting. However, its short futures contract will be trading for a higher price so it can offset this loss. The gain on the futures contract is 7850-7820 = 0.0030. Therefore, Lexus will make 0.000030 * 125,000,000 = $3,750 from the sale of the contract for a total cash inflow of $975,000 + $3,750 = $978,750, which is a $2,500 shortfall from the $981,250 it was expecting.

This is basisrisk from a short hedge. It occurred because the contract had not expired at the time the hedger needed to get out of the contract. Had they been able to sell a two-month contract, the futures price would have converged to the spot price, leaving them with no shortfall.

Example 2: Basis Risk of a Long Hedge

We can use the same example to show basis risk of a long hedge. All we have to do is look at it in terms of the hedger on the other side -- the long futures contract. Let's assume the U.S. Lexus dealer buys 10 three-month contracts at 7850 but must take delivery of the cars in two months. The car dealer realizes he is going to pay 125,000,000 * .007850 = $981,250 in two months and wishes to hedge any price increases in the yenby purchasing the yen contract. This long hedge will rise in value if the yen should rise, which will offset his costs.

At the time of delivery, the yen is trading for 7860 but the futures contract is only trading for 7857. The dealer, expecting to pay $981,250 must now pay 125,000,000 * .007860 = $982,500. Because the yen is higher, he can sell his 10 futures contracts at a profit to offset his cost. However, he will only receive a profit of (.007857 - .007850) = $875. His costs were $1,250 higher but he only receives $875 of this back from his futures contract -- that's basisrisk of a long hedge.

You may think, "Why doesn't the car dealer use his futures contract and just purchase the yenfor 7850?" Remember, futures are not options. The futures contract expires in one more month, and that's the agreed upon time in that contract to buy and sell the yen -- not today. The dealer can therefore only use it as a hedge. But as we just mentioned, those hedges do not always work perfectly. Of course, it's possible that the dealer may wish to purchase an extra contract to make up for any losses through basis risk. That's certainly okay to do and happens quite frequently in practice. However, it does not come for free as the dealer must post more money for the initial margin requirement, which may or may not be advantageous from a business standpoint.

We can show the effects of basis risk mathematically. Assume a futures contract price today is F₁ and F₂ when it is closed. Likewise the price of the underlying stock is S₁ today and S₂ at the time the futures contract is closed. From our previous definition, we know that basis is the difference between the futures price and spot price so the basis today, B₁, is:

B₁ = F₁ - S₁

Similarly, the basis in the future is:

B₂ = F₂ - S₂

Consider our U.S. car dealer who purchased a three-month contract to hedge the purchase price of yen two months in the future.

At the time the contract was purchased, the spot price was S₁ and the futures were purchased for F₁. When the contract was closed, the car dealer purchased yenin the open market at a higher price, S₂, and receives F₂ from the sale of the contract. His total gain on the futures contract is therefore (F₂-F₁) and he spends S₂ for yen in the spot market. The car dealer's total cash flows are then:

(F₂-F₁) - S₂

This can be rearranged as:

(F₂-S₂)- F₁

However, F₂-S₂ = B₂ so we can rewrite the car dealer's cash flows when he closes the contract as:

B₂ - F₁

It is the uncertainty of the future basis that poses the risk for this long hedge used by the car dealer. He receives B₂ and purchased the contract for a price of F₁ for a net gain of B₂ - F_1. It should now be evident that this unknown spreadbetween the futures price and spot price, the basis, is what presents a real risk to futures traders.

During section 3 of the course, we showed how arbitrage keeps the futures and spot prices reasonably close together so basis risk is not without bounds. In fact, the basis is more predictable for financial futures than it is for commodities due to minimal storage costs for financials. However, if you are trading a large number of contracts (or if the multiplier on the contract is large) and using them to hedge, just be aware that you could still come up short because of basis risk.

Strengthening and Weakening

The basis,we said, is defined as the difference between the futures price and the spot price, which can be written as:

Basis = F - S

where F is the futures price and S is the spot price of the underlying asset. If the futures price rises by a larger amount than the spot price, the basiswill increase. This is known as a strengthening of the basis -- the spreadis getting bigger. Likewise, if the spot price rises faster than the futures price, the basis will shrink, which is known as a weakening of the basis.

While it is possible to come up short due to basisrisk, it is also possible that it may help you. For instance, in the first example where we looked at basis risk of a short hedgewe assumed the Japanese firm sold the yen contracts to protect their price at the time of delivery. If the yen falls relative to the dollar, the Japanese firm will offset their losses with the short futures contracts that will rise in value. But suppose the yen falls and, since we are not at expiration, the price of the futures contract falls more than the spot price -- a weakening of the basis. If so, the Japanese firm makes more money from the futures hedge than is necessary to offset its losses on the yen. If you are short the futures contract, a weakening basis will help you.^[2] Similarly, if you are long a futures contract then a strengthening basis will help you. It will provide money on top of that necessary to offset your losses from any increases in the spot price.

If you are familiar with options, basis risk may sound familiar. In options trading, it is called implied volatility risk and is very similar in nature. With options, it is possible to see your contract trading for a lower amount, even though the underlying stock moved in your favor. This occurs because supply and demand differences caused the implied volatilities to change in an unfavorable direction. Basis risk is a similar concept.

While basis risk is a problem for both speculative and hedged positions, be aware that it is usually more serious for the hedger. A speculative position that doesn't make as much profit as expected is missing out on speculative profits. While that may not be fun, you'll have a hard time convincing someone of the "risk" to which you were exposed. However, if you are hedging a position with the intent on ensuring a purchase or sale price and there is a shortfall, that could very well create a serious hardship.

[1] For commodities, the basisis usually defined as the spot price minus the futures price. However, it is conventional for financial assets to define the basis as futures price minus spot price. Because we are primarily dealing with financial assets in this book, we will use this convention.

[2] This is assuming our definition of the basis, which is futures price minus spot price. If you use the conventional definition, which is spot price minus futures price, you will get the opposite answer - a short futures position will be helped by a strengthening of the basis.

The Rewards and Risks of Futures Contracts

Throughout this course, we've highlighted various risks and rewards of futures contracts. Now we're going to concentrate on them and give specific examples to make sure you know and understand it. Parts of this course will serve as reviews and others will not. Considering what we've covered so far about futures, all of these rewards and risks should now become clearer.

The Rewards

• Lower margin requirements
• More cash-efficient way to trade
• Greater leverage without interest expense
• Highly liquid
• 24-hour trading
• Global diversification
• No uptick rule to go short
• Long and short positions created with equal ease
• Futures force you to make a decision
• Futures contracts create greater efficiencies for goods and services for the overall economy.

Lower Margin Requirements

We said in an earlier course that if you buy stocks on margin, you can pay for half the amount (subject to a $2,000 minimum) and borrow the other half from your broker. For example, if you buy $10,000 worth of stock, you are only required to pay for half of it, assuming the stock is marginable and you have a margin account. If you choose to do this, you must put down $5,000 of your own money.

Single-stock futures will have a much smaller initial margin requirement, which you now know is called initial margin or a performance bond. If you buy $10,000 worth of a stock through the futures markets, you would only be required to post $2,000. Some firms even pay interest on these deposits and many will accept bonds at about 90% of face value or stocks at about 50% of face value in lieu of a cash deposit. This will be especially useful, since most stock brokerage firms will also trade futures and you can use the stocks or bonds in your portfolio as collateral.

There is another inherent benefit with this lower requirement. It allows for a greater degree of diversification because less capital is required to control the same number of shares. For example, if you have $40,000 to invest, you may only be able to buy a small group of the stocks you'd like to own. Because of the low requirements on futures, you could purchase far more companies and thus provide a greater degree of diversification.

More Cash-Efficient Way to Trade

Futures are a traders dream because of the daily process of marking to market.

To understand why futures are more cash efficient, let's compare the purchase of stock and a futures contract under the same terms. Assume you bought 100 shares of stock at $50 and it is now trading for $60. You have an unrealized gain of $1,000 -- you have a "paper profit." That unrealized $1,000 could be working for you in other places, even if just sitting in the money market earning interest. But you can't get to it without exiting the position. In order to realize that $1,000 and put it in your pocket, you must sell the stock. If you do, you now may miss out on a bigger upward move.

Now let's look at the futures contract. If you had bought the futures contract at $50 and it is now trading at $60, your account would have $1,000 cash sitting in it and earning interest because of the daily mark-to-market. You want to use it to buy more contracts? How about some options? Or maybe you need it for a down payment on a car? Regardless of your needs, the cash is there and you can access it without exiting the position. There is no other financial asset that allows you immediate access to gains without closing the position first.

Greater LeverageWithout Interest Expense

We showed earlier how futures contracts provide for tremendous leverage. With the proposed 20% initial marginfor single-stock futures, that creates 5:1 leverage. With stocks, you could elect to pay for half of the position and borrow the other half from your broker thus creating 2:1 leverage.

However, if you borrow money from your brokerage firm to buy stocks, you must pay margin interest, which is normally just higher than the broker call rate(also known as the call money rate), which can be found daily in The Wall Street Journal. The broker call rate is usually lower than most short-term interest rates, including the prime rate or even T-bill rates, due to the fact that brokerages are securing the loans with collateral (stocks). The point is that you get less leverage with stocks and must pay interest to do so! Margin interest can turn out to be a huge expense for stock traders and is one of the main factors that make it so hard for them to turn a profit over time. The stock may go up and down or even sit flat, but that margin interest keeps accruing on a daily basis.

Remember, buying a futures contract is not the same as buying the underlying asset today. It is a contractual obligation to buy that asset in the future. Therefore, the futures trader is not borrowing money so there is no interest due on a loan.

We can show this in the following example. Assume one person buys 300 shares of stock at $50 and another buys three futures contracts on the same stock. We'll assume both positions are closed at the end of three months with the stock at $58 and broker call rates are 5% per year. The following table compares these two traders:

	300 shares = $15,000	Three futures contracts = $15,000
Initial deposit	$7,500	$3,000
Gain on closing trade	$9,900	$2,400
Gross profit	$2,400	$2,400
Margin interest	93.75	$0
Net profit	2,306.25	$2,400
Percent gain	30.75%	80%

The trader who buys stock must deposit half the amount, or $7,500, and will pay interest on the $7,500 balance they are borrowing. The futures trader, on the other hand, only deposits 20%, or $3,000.

At expiration, with the stock at $58, the stock trader can sell 300 shares at $58 for a total of $17,400 but must repay the $7,500 loan for a gain of $9,900. After subtracting the $7,500 initial deposit, that leaves a profit of $2,400 or a net profit of $2,306.25 after margin interest.^[1] Because they initially deposited $7,500, their percentage return is $2,306.25 / $7,500 = 30.75%. We can also show this with some quicker math. The stock rose from $50 to $58, which is a 16% increase. The 50% deposit results in 2:1 leverage for a total return of 32%. However, they must repay 5% * 1/4 year = 1.25% interest for a total gain of 32% - 1.25% = 30.75%.

The futures trader, however, only posts 20% of $15,000, or $3,000. At expiration, the stock is up 8 points for a gain of 8 * 300 = $2,400, which is an 80% return on investment. Notice how the futures trader keeps the full $2,400 since there is no margin interest charge.

Whether you buy stock or an equivalent futures contract, your profits and losses will be exactly the same in terms of total dollars. Both of the traders in the above table made $2,400 gross profit. But due to the lower marginrequirement of futures and no margin interest charge, your percentage returns will be much greater for futures over stocks.

Highly Liquid

Futures contracts are often highly liquid, which you know by now means that there are a lot of buyers and sellers at any given time. This is a good quality as it makes the bid-ask spreads narrow and makes it easy to enter or exit a position quickly. It's one thing to talk about great benefits and strategies associated with futures contracts, but if you can't execute them, they're nearly useless. The highly liquid nature of futures contracts ensures that strategies of going long, short, changing directional bias, and hedging can all be carried out quickly and efficiently.

24-Hour Trading

The U.S. stock market normally operates between 9:30 a.m. and 4:00 p.m. Eastern Time. This creates a huge problem if some news event occurs and you wish to enter a position or hedge an existing one -- you can't do it until the market opens. Futures, however, trade nearly 'round-the-clock through automated systems such as GLOBEX, which is a proprietary computerized trading platform at the CME. Now you can access the markets just about any time from anywhere in the world. Aside from this benefit, there are other benefits that filter down to the stock market too. Because it's easier for the investors to access the markets, all information will be disseminated into the stock market quicker, thus creating narrower spreads and lower volatility.

The normal operating hours for single-stock futures will be 9:30 a.m. to 4:02 p.m. Eastern Time. The nearly 24-hour access is through automated systems such as GLOBEX.

Global Diversification

It can be shown that diversification is the key to minimizing the risk of any stock portfolio for a given level of risk. While the mathematics are beyond the scope of this course, just understand that the ability to access foreign markets with ease is a great advantage to investors. Up to now, most who sought global diversification used mutual funds or stocks of companies with global exposure. Mutual funds, however, usually offer a specific country and are rather limited in the selections. Using U.S. stocks as a proxy for global exposure, such as the purchase of Coca-Cola or General Electric, obviously has very limited impact, if any, on your overall portfolio from a global exposure standpoint.

Futures though, give you access to many different types of diversification quickly. You want exposure to the Canadian dollar, Euro, British pound, Deutshe mark, or Japanese yen? Or how about something more exotic such as the Australian dollar, South African Rand, Russian ruble, New Zealand dollar, or Swiss franc? It can now be done quickly and easily with futures. You can even get "baskets" of stocks with index futures in Japan, Germany, Taiwan, Italy, and many other countries around the world. In one transaction, you now have immediate and focused exposure to your areas of need.

Maybe there is there an oil crisis. Now you can capitalize by purchasing oil futures. Better yet, buy oil futures and sell airline single-stock futures (or indexes). Futures markets are your gateway to capitalizing on how world events impact the financial markets. You cannot get international exposure more efficiently than with futures contracts.

No Uptick Rule to Go Short

We said earlier that traders could make money from a downturn in stock price by going short. However, there are several stipulations:

• The stock must be marginable
• Your broker must be able to locate the shares to short
• You are subject to hefty margin requirements
• The short sale must be done on an uptick, which means you may receive an unfavorable price

The one stipulation that hangs most short sellers is the uptickrule. What is an uptick? Very simply, any change in the price of a security is known as a tick. For instance if a stock is trading at $100 and the next trade is at $100.10, that's an uptick -- the change in price was up. Likewise, if the next trade were back down to $100, that trade would be a downtick.

What happens if there's no change in price? Let's say the next trade was from $100 to $100.25 (uptick) and then the following trade was also at $100.25. This last trade is said to take place on a zero-plus tick. That means that there was no change between it and the previous trade or trades, but if we look back to the last time a change occurred ($100), it would be a plus tick. In fact, if you look at the system you use to get quotes, you will likely see a + or - sign in front of the last trades, which designates whether that stock or index is trading on an uptick or downtick (some systems will show the trades in green for uptick or red for downtick or may even use up and down arrows). The reason why exchanges track ticks is that any short sale must be done on an uptick or zero-plus tick.

This can create problems for the short seller. If you see an opportunity and wish to go short, you must wait for an uptick (or zero-plus tick ) before the trade can be executed -- even if you enter a market order. For example, say the stock is trading for $100 and negative news hits and you enter an order to sell-short 300 shares at market. Because of the news, the stock is in a freefall and is trading on downticks, with the tape showing the following trades:

100, -99.75, -99.50, -99, -98.50, -98, -97.75, -97.25, -96.50, -96, -95.75, +95.80

Your trade would be filled on the uptick at $95.80 even though you entered the order when it was trading at $100. The exchanges imposed this rule after the Crash of '87 to prevent traders from short-selling stocks that are in a freefall thus putting more downward pressure on them and nearly guaranteeing an unfair profit. Another problem the uptick rule creates for traders is that by the time upticks start to show, that may be close to the equilibrium point of the stock's price and it ends up stabilizing at the price where you sold. That can be frustrating when your judgment leads you in the right direction but a market restriction keeps you from profiting. This is not to say that the uptick rule shouldn't be in place; we're just saying that it creates problems for those wanting to short stocks.

In fact, it is for this reason that the stock market has a "sell short" order that is separate for a "sell" order. There is a need to separate the two orders since a sell short order is bound by the uptick rule. With futures you either buy or sell. If you wish to be short a futures contract, you enter an order to sell and you're short. It's that simple.

Long and Short Positions Created with Equal Ease

This may sound like a rewording of the previous benefit. However, we're talking about a little different aspect here in the sense of the marginrequirements. If you short a $100 stock, you must put up half that amount (Reg T requirement) and post $50 cash or margin cash. Let's say you want to short 1,000 shares at $50. You must put up $25,000 of your own money in order to do so. In addition, individual firms may have stricter requirements, especially if the stock is volatile, and require more money up front.

With futures contracts, people are agreeing to buy and sell at a point in the futures. Both parties post (pay) the same requirements and then are marked to market daily. If you sell a futures contract valued at $50,000, you will only be required to post 20%, which makes it much cheaper to establish short positions. Whether you are long or short a futures contract does not matter from a margin standpoint but can make a big difference with stocks!

Futures Force Disciplined Trading

Because of the daily mark to market process with futures, they force you to make a decision rather than taking a passive route. For example, you may have a stock that you bought and it trends down slightly, day after day. Eventually, you're in a larger than expected loss and it becomes that much harder to sell it for a loss. Many times you will end up hanging onto it only to watch it slip further. Futures contracts, however, will force you to take a closer look at the position and your decision for entering it. If you keep sending money to your broker for daily mark-to-market, or for variation margin, it will cause you to make an active decision to continue holding it. If you hold fully paid-for stock, however, it's much easier to ignore the downturn and end up with much larger losses. Futures contracts force a more disciplined trading style.

Futures Contracts Create Lower Prices

Besides hedging risks for individuals or corporations, futures contracts provide another important economic benefit for all of us -- they create lower prices of the underlying assets. For example, farmers are more willing to grow wheat if they know they can lock in a sales price today. The wheat takes time to grow but the risk of a lower sales price is removed through the futures markets. With reduced risk, farmers are willing to provide more wheat so the supply rises and wheat prices fall, which is better for everyone who is a buyer of wheat.

On the other side of the farmer's trade, a cereal manufacturer may wish to buy wheat for their next operating quarter. The rising cost uncertainty they normally would face is a deterrent to manufacturing cereal. Faced with this risk, cereal companies would tend to produce less cereal. Why would a cereal company want to take orders for millions of boxes of cereal from grocery stores if they're not sure they can provide them at a profit? In fact, if wheat prices rise significantly, they could end up with huge losses or even bankruptcy. The futures markets remove the risk of rising prices so cereal companies can provide a larger supply -- and lower prices -- of cereal.

The Risks

You could lose more than your initial deposit Leverage: emotional risks Limit moves in the underlying Basis risk

As with any financial asset, the great rewards and benefits of any product do not come without some sort of risk. While this is not an exhaustive list, we will attempt to address most of the risks associated with futures trading.

You Could Lose More Than Your Initial Investment

As we stated in the beginning, futures are not optionsand you can lose more than your initial margindeposit. Remember, the initial deposit is a "good faith" deposit that you will either deliver or take delivery of the underlying asset at the predetermined price, assuming you do not enter an offsetting contract. If you buy the contract and the futures price falls significantly, you will be required to deposit more money. Theoretically, if the price move is large enough, you could end up with negative equity, which means you must send your broker a check just to get your account back to a balance of zero. Normally this is not a concern because of the daily price limits allowed on most commodities. However, with single-stock futures there are no daily price limits, so your account values could swing significantly.

Of course, the way to manage this risk is to monitor your positions closely and don't let losses run against you too long. In fact, many futures firms offer managed accounts where the broker will trade your account for you, which can certainly be an advantage if they have the same trading ideals as you.

Leverage:Emotional Risks

We showed earlier that leverage is an asset and now we're showing that it is also a risk. This is consistent with our earlier comment that leverage is a double-edged sword -- it can work for and against you.

While the physical leverage qualities are a risk in itself, what's probably more of a risk is the emotional risk that is tied with it. Can you stand to see hundreds or thousands of dollars vaporized from your account in a potentially short time? Will you have the discipline to exit the position? Or maybe the better move is to sit tight, do nothing, and maintain your convictions. If so, will you be able to do that? It's one thing to say that you can and an entirely different one when you're dealing with real money. It is this highly emotional state that can cause you to make the wrong decision.

Understand that emotional risk exists, even among professionals, and know your limits.

Limit Moves (or Lack of) in the Underlying

In a prior course, we stated that single-stock futures would not have price limits. This is a very real risk when you consider the leverage you're dealing with. If the price is only allowed to move so much, as with most commodities, there's only so much of a loss that can occur in any given day. With single-stock futures, there is no price limit protection. While this may seem negative, we'll soon explain that it doesn't really make a difference from a theoretical point of view.

Most commodity contracts have daily price limits -- upper and lower bounds -- that cannot be exceeded during the day. If a boundary is broken to the upside, that commodity is said to be locked limitup or just limit up for the day. Similarly, if it is to the downside it is limit down. It certainly seems like limit moves serve to improve the integrity of the commodities markets by limiting losses on any given day. But think about this. Assume you are short a contract and wish to buy it back. However, the underlying commodity is limit up and trades can only occur inside of the daily price range. While trades are allowed to occur inside this range, do you think anyone is going to sell to you if they are reasonably sure it will be higher tomorrow?

If not, commodities can remain limit up for extended periods of time, never giving you a chance to exit. After all, if the price is 100 today and, after new information, the market values the commodity at 120, the trading should theoretically not take place until the price is 120, even if it takes many limit up days to get there. Single-stock futures will not have daily price limits, which can be good and bad. While you will never be locked out of a trade, you will also never have limited moves to reduce losses. We'll show you in a later course how to protect yourself if you are locked out of a commodity trade that is locked limit for the day.

Once again, there are pros and cons to daily price limits but, at least theoretically, there shouldn't be much of a difference between the two methods. Just be aware that single-stock futures will not have daily price limits, so losses can accrue quickly if you are not watching your positions closely. Also keep in mind that the lack of price limits, in itself, is not a reason to fear single-stock futures as losses that occur are no greater, in total dollars, than if you just held the stock. On a leveraged basis, however, the differences are very real. This brings up another point. If you are using single-stock futures as a means of long-term investing, make sure you leave some money on the side to cover potential maintenance margin calls. It is truly a speculative position if you enter it with no room for downside risk.

We're now going to turn our attention to perhaps the biggest risk that futures traders face, which is called basis risk. Because it is a special type of risk, we're going to devote an entire course to it.

[1]The trader borrows $7,500 for three months so owes $7,500 * 5% * 3/12 months = $93.75 interest.