Ideal investment if you can bear risk
A MARKET correction earlier this month saw a global sell-off of equities, with Asian stock prices taking a plunge.
Analysts attributed the downturn to financial uncertainty due to a slowdown of economic activity in China and a scaleback of quantitative easing that caused the currencies of emerging markets to tumble against the US dollar.
Most notably, on Feb 3, the benchmark Straits Times Index fell below the 3,000 level for the first time since November 2012.
But it's not all doom and gloom in situations like these.
Phillip Futures senior dealer Lee Choong Kit said the positive "light" is that investors can still profit from the market volatility, or hedge against the declining value of their stock portfolios, by turning to index futures.
"Investors also hold a good outlook for the US economy to improve and expand, and withstand the tapering of quantitative easing measures. It's a good time to go 'long' on the US equity index futures," Mr Lee added.
A stock index measures the performance of a stock market in different sectors. It consists of a basket of companies listed on their respective stock exchanges. For example, the Morgan Stanley Capital International (MSCI) Singapore Free Index, commonly called the SiMSCI, tracks 30 companies listed on the Singapore Exchange.
The companies come from various sectors, such as finance, telecommunications and shipping. Other well-known regional stock indexes include Japan's Nikkei, and Hong Kong's Hang Seng.
By trading in index futures, an investor is taking a view on the market - whether he expects it to be bearish or bullish.
There are two positions he can adopt - to go "short" (sell) or "long" (buy). In the former, the investor will agree, by contract, to sell the index futures at a set price, holding the view that the market will slide.
If his predictions are accurate, he can buy back the index futures at a lower price to deliver what he originally promised to sell them at, hence turning in a profit.
In the "long" position, an investor expects the market to go up, so he buys the futures at a set price and profits later by selling them at a higher price.
Whether going "long" or "short", the investor can choose to liquidate his position - taking profit, or cutting losses - at any time, or wait until the expiry date, which is usually the last trading day of the month's Stock Index Futures contract.
HOW IT WORKS
Using the example of SiMSCI, the value of one contract is the index price multiplied by $200. Hence, if the SiMSCI is at 337.1, the value of one contract would be $67,420.
In futures trading, an investor will need to come up with only an initial margin, which is around 5 to 15 per cent of the full contract value.
The initial margin acts as a deposit guarantee between the buyer and the seller, and represents an interest and agreement to take delivery of the underlying product upon expiry.
An investor is expected to keep the funds in his trading account above a certain level, known as the maintenance margin, which is decided by the brokerage.
Let's assume an investor deposits $2,000 in his account and buys one lot of SiMSCI contract which has an initial margin of $1,980.
Say the maintenance margin is $1,780. Thus, he will have an excess of $220 ($2,000 - $1,780).
If the SiMSCI price falls by 1.2 to 335.9, the investor will make a loss of $240 ($200 x 1.2). This reduces his account balance to $1,760 ($2,000 - $240).
As this is below the maintenance margin, the investor will get a margin call from his brokerage. He will be asked to top up his account by $200 ($1,980 - $1,780), the difference between the initial and maintenance margins.
With the top-up, he can continue to maintain his position and stay in the market.
If the market improves subsequently and the SiMSCI moves up to 337.6, he would have made a profit of $100 and at the same time recovered the initial loss and the additional $200 used to top up his margin call.
At the end of every trading day, a mark-to-market occurs, which means the profits and losses through the day are credited and debited.
GAINS AND LOSSES
With a small initial margin, investors can own a contract with a significantly larger value.
The SiMSCI can typically move about two to four points in a normal trading session, equating to profits or losses of $400 to $800 for one contract lot, depending on which position the investor has taken.
Leverage is thus a "double-edged sword", for while it can help investors make a tidy profit with just a small sum, it can also rack up huge losses, said Mr Lee.
In futures trading, timing is also of the essence.
Unlike stocks, contracts for index futures have an expiry date, which means investors are unable to hold on to their position for an indeterminate period of time, until the market swings in their favour.
Index futures are hence for those with an "appetite for risk", added Mr Lee.
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