How Do Futures Markets Guard Against Volatility?
Futures trading is sometimes blamed as the cause of market volatility, but studies of the use of futures in the markets, or introduction of futures to the markets, have found that they have no effect on volatility and are even a valuable hedge against volatility.
For decades, economists have debated how much futures trading affects the volatility of the underlying assets. A 2002 study of the introduction of stock index futures on the Italian Stock Exchange, found that the introduction of these futures actually reduce market volatility, to the exclusion of any other possible cause. The authors of the study drew a conclusion that having active and developed futures markets can enhance the efficiency of the corresponding spot markets, therefore reducing volatility.
looking closer to markets in India, a Clemson University economist, found no link between trading activity variables in futures markets and spot market volatility. The study noted that, in developed markets, there was no link between futures activity and volatility, nor was there destabilization of underlying markets. furthermore, in less developed markets such as India, the study found that introducing derivatives improved liquidity and reduced market asymmetry.
The general caution about futures trading potentially affecting volatility is fueled by the notion that introducing futures markets encourages speculation. However, the argument that futures markets merely speed up transmission of information, therefore increasing spot market volatility, was put forward even back in 2000, in a paper by a University of Durham (UK) economist evaluating futures based on the FTSE Mid 250 index. As a result, that economist argued, futures trading may be fully consistent with efficiently functioning markets. That conclusion almost exactly matches the first study cited above, about the Italian Stock Market.
In addition, trading options are a valuable hedge against short-term volatility. Traders can also turn to options spreads, rather than futures, when volatility is apparent in a market.
For short term traders volatility is a good thing and having futures and option strategies readily available create profitable risk reward trading opportunities. Our experts discuss futures and options trading strategies to help profit from volatility in the live stream each day.