Hedging Risk with Derivatives

Terry Flanagan

Much like with options, increases futures trading volume thus far in 2011 can largely be attributed to increased market volatility. Market participants are trading using alternative strategies in options and futures to hedge the risk associated with the underlying security.

According to Neal Wolkoff, chief executive officer of ELX Futures, a key factor for the strong trading volume in futures, in a market that has seen an overall decline in market activity, is that “futures markets are much more institutional-based. Participants are companies that have large amounts of risk in various underlying commodities.” This is in contrast to equities, which has a substantial amount of retail investor activity.

In addition, as market volatility has remained at an elevated level for much of the year, that will in itself increase risk. “Volatility levels have been fairly high,” said Wolkoff, adding that he debt issues surrounding the U.S. and Europe, as well as soaring inflation in China, have factored in to create uncertainty and increase volatility. “(Market participants) use the futures market to hedge that risk.”

“There’s a very close relationship between the need to hedge and increases in volatility,” added Wolkoff. “When markets become more uncertain and less predictable, I think institutions look at risk and become more and more concerned with the possibility of the unknown.”

ELX recently announced their trading statistics for July, noting a 69 percent year-over-year increase in daily contracts traded in the month. Certain of its products saw large increases in trading, particularly its Eurodollar futures and 30-year bond products, which saw market share increases of 397 percent and 807 percent, respectively. ELX, which saw its second anniversary tick by on July 10, had an increase of 162.6 percent in total contracts traded in calendar year 2010, to 13.1 million, from 5 million in 2009.

As far as the outlook going forward, Wolkoff believes it’s difficult to say what’s in store. “It’s always difficult to give a prognostication, I don’t sense any shortage of market volatility right now,” he said. “I think there’s a tremendous amount of uncertainty in the economic conditions in this country and around the world.”

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