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Futures and Options are risk management tools frequently used by institutional and retail investors to protect the underlying portfolio (hedging). Futures 1. Hedging This is usually used to protect the underlying portfolio especially in a bearish (declining) market when its value erodes. Example:
A retail investor with a RM500,000 stock portfolio consisting of KLCI top 10 counters. The investor would suffer the following losses should the KLCI decline by 8%. Stock Name | Price on 5 th May (RM) | Price on 17 th May (RM) | % Change | Maybank | 10.60 | 9.80 | (8) | Telekom | 9.80 | 8.65 | (12) | Tenaga | 9.45 | 8.80 | (7) | MISC | 12.50 | 12.20 | (2) | Maxis | 9.00 | 8.30 | (8) | Public Bank | 6.00 | 5.40 | (10) | BAT | 47.75 | 47.75 | Unchanged | Petronas Gas | 6.60 | 6.85 | +4 | CAHB | 5.10 | 4.46 | (13) | Sime Darby | 5.40 | 5.15 | (5) | Indices | Price on 5 th May (RM) | Price on 17 th May (RM) | % Decline | KLCI Index | 846.68 | 781.05 | (8) | MAY Futures | 840 | 750.5 | (11) |
**Average 10stocks decline (6 %) When the KLCI drops by 8% within the 9 days, the portfolio would have eroded 6% in value. The May futures contract would in turn have declined by 11%. For a retail investor with a RM500,000 investment portfolio, he can hedge its position by selling 12 index futures contracts as per the following calculation: | Value of Portfolio | x Beta | = No. of futures contracts |
| | | | Futures Index x Multiplier | | | | | | RM500,000 | x 1 | = 12 May futures contracts |
| (assuming Beta =1) | | | 840 x 50 | | |
Total capital outlay would be: | | | | | | Per contract | For 12 contract | Futures Initial Margin | | 1,200 | 14,400 | (placed with MDCH) | = | as at 5 May | | Brokerage | = | 25 | 300 | Exchange | = | 5 | 60 | Clearing | = | 1 | 12 | Total | = | 1,231 | 14,772 |
The impact of hedging: | 5 May | 17 May | Equity Portfolio value | RM500,000 | RM470,000 RM30,000 loss in value | Futures Hedge value | Entry point 840.0 | Exit point 750.5
Gained 89.5 points
Profit RM52,956
(after transaction cost)
| Net Profit / Loss | | Futures profit - equity depreciation Profit = RM22,956.00 |
The hedging would have protected the portfolio by allowing the investor to gain any corporate exercise during this period and also reap profit in a declining market. By placing a sell position in a declining market, the investor would ultimately make a net profit of RM22, 956. 2. Leverage This allows investors to have the same amount of exposure but with the benefit of a cheaper transaction cost. Example A nominal margin deposit of each Index Futures (FKLI) contract allows an investor to have an equivalent exposure of the underlying instrument shares. If an investor bought 1 FKLI contract at 800 | Futures | Equity | Exposure | 1 contract with a value of RM40,000 (800 x RM50 per point) | Need to buy one / several portfolio of stocks with a total exposure of RM40,000 | Cost | Initial Margin deposit of *RM1,200 per contract | Capital Outlay of RM40,000 |
*(subject to timely changes by Bursa Malaysia Derivatives Clearing House) You will get an exposure of 33 times with an initial margin of RM1,200 and 800-index futures level. Note: It is possible to gain or lose more than the margin deposited as a result of the FKLI’s high gearing. 3. Standardized Contract As it is exchange traded, the pricing and volume transacted is transparent to all market players. It results in high liquidity. 4. Ability to Sell First Despite a declining market, an investor can: - attempt to make a capital gain
- hedge/protect his portfolio exposure
This is a legal regulated short-selling activity 5. Lower Cost of Trading Although the contract value fluctuates, investors pay a fixed amount per contract, compared to a fixed percentage (in the equity market) 6. Trades Guaranteed by the Clearing House The Bursa Malaysia Derivatives Clearing House (BMDC) plays an important role by guaranteeing the financial performance of futures contracts traded on the exchange. It substitutes itself as the buyer to the seller and vice versa, of a futures contract. This eliminates counter-party risk.
Futures and Options are risk management tools, frequently used for protection of the underlying portfolio (hedging) by institutional and retail investors. Options Advantages of Options (similar to Futures) include: - Hedging
- Leveraging
- Lower costs of trading
- Trades guaranteed by the Clearing House
However, the difference is that market conditions could render the position to be exposed to unlimited risks. Option Buyer: Limited Risk and the prospect of Unlimited Rewards Option Seller: Unlimited Risk and the prospect of Limited Rewards You are requested to study and understand the characteristics, trading risks and possibilities prior to entering into options trading. Extensive understanding is required before you use options as an investment strategy.
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