Trading Futures
Volumes dwarf traditional stock markets, but they can make you poor as quickly as they can make you rich rich, writes Ciaran Ryan
The futures market is blamed for many of the ills of the world, from stock market crashes to the collapse of Barings Bank at the hands of a lone, out-of-control trader, Nick Leeson.
Closer to home, reckless speculation in futures brought banking groups Sechold, Decimax and Real Africa Durolink to their knees in just weeks. Such calamities deepen already entrenched perceptions of the futures market as a playground for misfits.
Individuals are capable of sinking multimillion-rand enterprises with devastating speed by taking one-way bets in the futures market. When the market moves against them, they double up and treble losing bets.
The attraction - and danger - of futures is that they are geared roughly 10 times to the movement of the underlying asset from which they derive their value - which is why they are called "derivatives".
You can buy futures contracts on maize, wheat, JSE indices like the Alsi 40 and Indi 25, bonds, interest rates and individual equities. Every 1% move in the underlying asset translates into 10% in the futures - known in financial markets as gearing.
This is a fast train either to riches or to poverty. For example, had you bought the Alsi on the futures market in early September last year at about 7 000 and sold in mid-April at 11 140, you would have made a profit of 600% - 10 times more than the JSE.
Each one-point move in the index is worth R10, giving a profit of R41 400 on the 4 140-point rise in the index over that period. The purchase of a single Alsi contract requires a margin, or deposit, of R7 000.
This is an example of a one-way bet or, in futures terminology, an unhedged position. Because each one-point move in the index is worth R10, the index need only drop 700 points to wipe out your margin of R7 000. At this point you have a choice: either exit the trade or cough up more margin.
Traders protect themselves against adverse market moves by way of a stop-loss - an instruction to the broker to close the trade at a predetermined level if the market moves in the wrong direction. In this way, losses are kept small.
Those who do not exercise stop-loss strategies - such as Nick Leeson - can end up pouring more and more margin into losing trades. Leeson bet the bank and lost.
One of the more common and conservative uses of futures is as an insurance against adverse market moves. Large fund managers use futures to hedge share or bond portfolios. This is a primary attraction of futures: the ability to make profits by buying in anticipation of a price rise (going long) or selling in anticipation of a price drop (going short).
If you hold a portfolio of shares but expect the market to decline, rather than sell the shares - which is not always easy to do and incurs costs, not to mention capital gains tax (CGT) - you could short an Alsi futures contract. Any decline in your stock market portfolio is offset, or hedged, by profits from the futures contract.
Bear in mind, while you might avoid CGT by not selling shares, you will be liable for CGT on futures profits.
Futures is a zero sum game: for every R1 of profit made, someone is losing R1. A speculator may buy a futures contract with a view to profiting from a price rise, while a hedger may sell the same contract to insure a share portfolio against a downswing.
Futures volumes worldwide have multiplied over the past decade to the point where they now dwarf stock exchange volumes, yet the concept of futures is centuries old. Traders in the middle ages used futures contracts as price protection. They would buy grain from farmers at a fixed price before the crop was planted.
The same principle applies today. Farmers can sell grain at a fixed price for delivery months later. This gives farmers the comfort of knowing that, no matter what happens to the price of grain, the price is guaranteed.
The futures contract protects farmers from unforeseen events which might drive down the grain price, such as a market glut. The buyers of grain, such as millers, can also fix a price today for a quantity of grain to be delivered in the future.
Both the farmer and the miller clearly benefit by fixing prices in advance. They could agree on a deal between themselves, but it is far easier to do this via the futures market where the risk of price volatility is assumed by speculators. There are far more speculators than there are farmers, which explains why only 2% of futures contracts result in physical delivery of the underlying commodity.
The majority of futures contracts are traded for financial gain, rather than any desire for physical delivery of the commodity. The more participants there are in the market, the keener the pricing, which is why speculators - often maligned as the embodiment of capitalist greed - are a necessary part of financial markets.
Financial futures - such as in stock market indices, interest rates and bonds - are newer developments, but account for a huge part of trade.
A relatively new feature available on the SA Futures Exchange (Safex) is equity futures - in other words, futures contracts on individual JSE equities.
For those with large equity portfolios futures offer a cost-effective and efficient hedge against market decline. You can, for example, buy R1-million worth of Anglo American shares on Safex for a margin, or deposit, of R100 000 - geared 10 times to the movement in the share price.
Those expecting a drop in Anglo shares can protect their investment by shorting Anglo futures. Think of it as an insurance, where the cost is equal to 10% of the shareholding. Every 1% drop in the price will be exactly offset by gains in the futures market.
Another advantage of equity futures over JSE equities is cheaper trading costs: 0.35% versus about 0.75% on the JSE.
Arthur Buchner, head of derivatives at BoE Securities, says: "We're seeing a bigger number of private investors who understand futures and want stronger gearing than they can get on the JSE or through warrants."
Ryan Jonsson, a futures trader at Barnard Jacobs Mellet, says equity futures are simpler to understand than warrants. For one thing, the gearing is constant and easy to understand.
It's not only hedgers who are attracted to equity futures, says Buchner. Several traders made fortunes speculating on the rise in gold shares. Harmony's share price nearly trebled over the last nine months, but those who bought Harmony futures would have done 10 times better than this.
More recently, there's been an increase in short positions on gold shares as traders and hedgers anticipate a market correction.
Equity futures are ideal for conservative investors seeking to hedge their share portfolios, or for sophisticated speculators with strong views on share price movements. They are not for the average investor, bearing in mind the penalties of calling the market incorrectly.
Each equity futures contract is for 100 shares and has a life of just one quarter or three months.
A Tale of Two Traders
Go with the trend but watch your back
Barry Cameron started trading futures in 1990 when he worked as a professional trader with stockbroker David Borkhum Hare, later acquired by Merrill Lynch.
Just over a year ago he decided to go it alone, trading for his own account.
"I have a simple market philosophy, which is to go with the trend," he says.
"If the market is moving up, I don't try to buck the trend."
Cameron uses a combination of technical (charting) and fundamental analysis to guide his trading decisions, and seldom holds a position for more than a few days.
"The attraction of equity futures for me is the flexibility to move in and out of individual equities quickly.
"In addition, one has the ability to gain exposure to a large number of stocks with far less capital than is required on the share market."
Those who went long on equity futures in recent months would have made a fortune, multiplying gains on the share market 10-fold.
Warren Benvick of Port Elizabeth was happy nursing his stock portfolio until a friend told him about the fortune he had made in futures during the 1998 market crash.
"I started off very small, just trading on a day-to-day basis; slowly I started building up my cash reserves. I simulated trading using my stock market charting programme. This helped me gain experience and confidence before risking hard cash."
Like Cameron, he uses a mix of technical and fundamental analysis, focusing on the trend in the key indices - the rand-dollar exchange rate (and its likely effect on the market), the state of overseas markets and trends in those stocks with the highest weightings in the indices.
This analysis is done daily.
"It's important to have a simple technical trading plan to time your trades," he says.
Benvick offers the following tips to would-be traders:
Manage your money strictly and use a stop-loss - a predetermined sell level in case the market moves against you, designed to limit losses to maybe 5% or 10%.
Start small and build up your trading account over time.
Plan each trade and set price objectives.
Study as much as you can about the markets, charting and trading systems.
Simulate trading before committing real cash to hone your trading skills. |
