The Advantages and Disadvantages of Hedging Using Futures

The advantage of hedging using futures includes it is liquid and can be traded in the central market. This means that the futures can be purchased or sold rapidly in the central market. This is because futures contracts can be traded in the central market where there are many market participants. When there are many market participants who trade futures in the central market, it will increase the level of liquidity due to there are many market participants will enter and exit from the position such as long and short. This will then cause the market participants more easily to buy and sell the futures in the central market. Also, this will cause the trader to close out his or her position easily by just making a reverse transaction in the central market.

Next, the advantage of hedging using futures includes leverage. This means that by depositing a small value of deposit on the assets being traded, it can greatly magnify gains (or losses). This is because the margin system has a function of allowing a trader to undertake a larger position by depositing only a small value of deposit or initial margin. For example, a futures contract with a value of $1,000,000 has an initial margin of $100,000, with every percent change in the futures price, it would cause approximately 10 percent change in relation to the trader’s initial cost. This magnification of gains (or losses) is termed as leverage. This leverage will offer a chance for the trader to hedge larger amounts by using a smaller cost.

Besides that, the advantage of hedging using futures includes the position can be closed out easily. This means that trader can terminate or move out from the position such as long or short without consuming much time and efforts. According to (Ben-David), this is because when a trader wishes to close out his or her position in the market, he or she can just simply make a reverse transaction any time before the expiration date in the market and close out that position. For example, if a trader wants to move out from a position and he or she had sold 10 Dollar futures contracts expiring in June, then he or she may make a reverse transaction which is purchasing 10 June Dollar futures in order to close out that position.

Also the advantage of hedging using futures also includes convergence. This means that when the futures contract is close to the expiration date, the futures price and spot price will move closer to each other. In other words, the futures price and spot price will be inclined to converge when the futures contract is near to its delivery date. For example, when the futures price is above the spot price, the futures price will decline to meet the spot price whereas the spot price will rise to meet the futures price. Hence, on the expiration day or delivery day, both the prices must be equal. This convergence comes from the activities of arbitrageurs when they notice the price inequalities between the futures and the spot and they intend to make a profit from it. For example, buy the cheaper one and sell the higher priced one.

Disadvantages of Hedging Using Futures

The disadvantage of hedging using futures includes it is a legal obligation. This means that there is an obligated action which the holder is compulsory to execute it. This is because futures is a contract and it required the holder to perform its action as stated in the contract. This legal obligation may cause some difficulties to the business community. For example, if hedging is done through futures for a plan that is still undergoing in the bidding process, the futures position might become a speculative position if the bidding ends up unsuccessful.

Next, the disadvantage of hedging using futures includes it has standardized features. According to, in order to make trading possible, there must be standardized features since the buyer and seller never meet. This means that all the futures contract must adhere to the same standard and set guidelines. As a futures contract has standardized features in term of some characteristics such as contract size, and expiry date, perfect hedging may not be able to happen. Since overhedging is also normally not advisable, a certain portion of the spot transactions might remain unhedged.

Furthermore the disadvantage of hedging using futures includes initial and daily variation margins. This means that there is a changing of the margin every day according to the market. As we know, a trader must make an initial margin or deposit before he or she takes a position in the futures market, and this deposit will be returned to the trader when he or she closes the position. Futures contracts are based on the market and the futures can be traded on a daily basis. Therefore, when there is a daily loses, the trader is obligatory to top up to the daily variation margins and this may cause the traders or hedgers to suffer in a huge amount of cash burden especially when there is a high variation which will cause a huge daily loses.

Lastly, the disadvantage of hedging using futures also includes it might forego favourable movements. This means that sacrificing the good movements that will generate gains for the trader. In hedging using futures, the losses or gains in the spot transaction can be balance by the gains or losses from the futures transaction. For example, when a trader feels that the Dollar futures will depreciate in the future, he or she sold the dollar futures and expect it to depreciate. However, if the Dollar goes to the reverse direction of the trader’s expectation and were to appreciate instead of depreciating, the trader will then have to sacrifice such favourable movements.