Single Stock Futures

Transcription

1 Single Stock Futures

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3 Single Stock Futures (or Individual Equity Futures) are exchange traded derivative instruments offering investors amplified exposure to price movements in a wide array of listed shares. A futures contract constitutes a legally binding agreement on standardised terms between two parties to buy or sell a specified underlying share at a fixed price on a predefined date in the future ( close-out date ). In South Africa, Futures are traded on the Equity Derivatives Market of the JSE ( the exchange ) and the quarterly futures close-out occurs on the third Thursday of March, June, September and December (or the previous business day). One futures contract exposes the investor to 100 underlying shares, whilst only requiring a predefined nominal amount of Rand cover per contract as initial margin against the full nominal exposure sought in the underlying shares. Margined capital efficient investment High gearing potential Low transaction costs Price transparency Exchange regulated trading Settlement guaranteed How do futures trade? Futures trading and margining is regulated by the exchange, which is in turn regulated by the Financial Services Board. This stringent regulatory hierarchy and the related policies ensure that all participants are protected from counterparty credit and settlement risk. Single Stock Futures trade in linear correlation to movements in the underlying shares and, due to the margining process, returns are subject to notable leverage. Unlike options, which have an asymmetrical risk profile, the pricing of a future includes no probability Greeks and exposes a one-for-one relationship to the underlying share price, net of any funding, dividend and costs assumptions as determined by the market maker. Clients wishing to trade in Single Stock Futures need to register with an authorised JSE Equity Derivatives member ( broker ), who will then arrange for registration forms to be lodged with the exchange and arrange for the initial margin to be paid into the new account on the client s behalf.

4 Who are the market makers? Market makers are large cap banks or financial institutions that effectively use their balance sheet to hedge clients long and short futures positions in the underlying spot market. For example, by buying the full exposure in the shares as sought by a long futures holder, the market maker effectively lends the holder the balance of the shares not covered by the initial margin requested by the exchange. Mark-to-market and margin implications Market makers make continuous intraday prices (to go long or short or close either side) based on where the underlying shares are trading, and all outstanding positions are marked-to-market to the closing price of the shares by the exchange on a daily basis. When a position is opened, clients are required to pay an initial margin deposit of approximately 10% to 30% of the total exposure in the spot market (depending on specific exchange criteria and the individual circumstances of the client as determined by his or her broker). This initial margin remains on deposit for so long as the client has an open position. After commencement of a particular trade, the position will be marked-to-market daily, with the fair value of the future is based on the last traded price in the share for the day. The daily adjustment to the investor s margin account (as determined by the marked-to- market calculation) is termed the variation margin. Any shortfall/surplus will be debited/credited to the client s account on the following day. Should the balance on the client s margin account at any time fall below the required minimum, the client will be called to make up the shortfall immediately. This process works on both sides of the transaction, in that both clients and market makers are required to top up any shortfalls on an intraday basis The exchange and participating brokers credit all client margin accounts with daily interest at the prevailing overnight rates. Example: A client buys 10 ABC Ltd (ABC) contracts at a spot reference price of R60 (ignore the effects of interest and dividends for ease of understanding). The nominal exposure of this contract is therefore R (10*100*R60). The exchange determines that a margin of R900 per contract is required to trade this particular underlying, and asks that the client places R9 000 (R900*10) in a registered SAFEX account. The investor has R in cash at his disposal and transfers this amount into his account (R9 000 margin and R1 000 cash). Should the share price fall in value to R55 the next day, a theoretical nominal loss of R5 000 has been incurred by the investor. After being marked-to-market against the R55 close in the price of ABC, the investor s account should now show a balance of R9 000 margin and negative (R5 000) cash. Due to this shortfall, the investor will now be called to top up the account by R5 000 immediately, so as to maintain the initial margin requirement as set by the exchange for 100 contracts of ABC. Failing this, the client s broker will act and close the position. If, on the other hand, the market price had improved to R65, the account would now register a balance of R9 000 margin and positive R5 000 cash (which the investor would then be entitled to withdraw up to the R5 000 limit). Any failure to honour a variation margin call to top up the margin account within the prescribed time (usually by 12h00 the next business day) will result in immediate closing out of the position by the client s broker. Any positive variation margin credited to a client s account as the result of a positive move up or down (depending on the direction of the original position) may be withdrawn by the client, subject to the maintenance of the stipulated minimum initial margin requirements of both the exchange and the broker.

5 Liquidity A position in any given Single Stock Future may be liquidated (or closed out ) at any time to expiry. This is achieved by simply initiating an equal but opposite trade to the current position held (close long or short). For example a long futures holder exposed to a long position in the underlying shares through the market maker s hedge, the closing entry would be to instruct the market maker to sell the shares in the market and reference the closing price in the futures to the share sale price achieved, adjusted for any funding left to the contract expiry period. A Single Stock Futures position held until expiry will result in physical settlement of the underlying shares (long futures holders will be compelled to buy the shares from the market maker at the closing price on the expiry date), unless the position is rolled forward into the next contract period prior to the last day to trade. The official close out price at expiry will be determined by the exchange. Why trade futures? Single Stock Futures are highly geared instruments, allowing investors to benefit fully from rising or falling markets by going long or short at a reduced capital outlay. Portfolio managers may use short futures positions to hedge existing baskets of shares, whereas traders may speculate on expected market shifts by harnessing the power of leverage. Single Stock Futures allow investors to enhance the performance of their equity portfolios, protect their investments against adverse price movements in the physical market (by going short futures) and diversify risk cheaply. Contracts are only written over liquid blue chip stocks and are thus easily tradable in the secondary market (if there s a price in the spot market, there s a price in the future). Futures offer gearing through margining. With margin requirement of approximately 10% to 30% of the total exposure, capital is freed up for investment in alternative vehicles. The same gearing also allows investors to hedge existing long portfolios of stocks. Single Stock Futures dealing enables exciting new trading capabilities, including pairs trading. This involves the simultaneous buying of one share and selling of another. The objective is to take a position on the relative performance of two tightly correlated shares usually from the same sector. Should the outlook of one stock look more favourable than that of another, one could buy the former and go short of the latter. This decision is usually based on quantitative analysis of the recent correlation between the two shares. Such an arbitrage not only locks in range divergences but also diversifies sector risk, resulting in relative cost efficiency.

6 Choosing the right futures contract A successful share investment is based on a justified and compelling market view. An investment in a Single Stock Future asks only a little more: not only a strong market view but also a succinctly timed buy into that view. Unlike shares, which can be held in perpetuity, Single Stock Futures expire and must be closed, exercised or rolled over on the close-out date. As the performance of the underlying share is the most important function in the pricing of a Single Stock Future, the investor must choose a contract on a share in which he has a solid market outlook. This outlook can be compiled through fundamental or technical analysis, or a combination of the two. By accurately forecasting the trend of an upcoming share price movement, an investor can make tidy geared profits in related long and short futures positions. The golden rules Have a confident view in the underlying share. Be aware of the margining effects on gearing up exposure. Note the effects of the time value of money and the related funding criteria inherent to Single Stock Futures pricing. Maintain tight exit and stop-loss levels. Risks As much as clients are geared to the upside should things go their way, they are equally exposed to the downside should the market turn against them. Futures are not capital protected, and clients may lose or make significantly more than their initial margin. Why trade Single Stock Futures through Investec? We offer tight spreads due to very competitive funding assumptions, and we endeavour to offer unparalleled levels of service to clients. Our pricing is transparent and all dividend assumptions are readily available to the market on a request basis. We use our own wholesale Treasury lending and deposit rates as agreed with the ICIB Money Market Desk, translating into cheaper costs of funding into the retail market than available through traditional lines. The product is simple and easy to understand. We offer broker clients access to the Perfix Trader online automatic futures trading platform, enabling direct market access to shares and related futures prices through a web-based link to our futures hedge book

7 Pricing Below is the formula to calculate the forward value of an underlying S : F = Se (r-d)t Where: Se* = Spot price of underlying share S r = risk-free interest rate compounding continuously (nacc) d = dividend yield of S compounded continuously (nacc) T = number of days in contract term/365 The spot price of the shares at the inception of the trade is adjusted by the forward interest rate to the expiry date less the present value of any dividends expected within the contract period. A correctly predicted dividend will leave the futures holder unprejudiced by the share going ex on the dividend date. This risk can be eliminated by trading dividend futures. The dividend, less withholding tax, if any, will be priced into the future calculation. Frictional costs including execution fees, securities lending/finalising costs and commission for the market maker are then factored into the pricing. Dividend futures When trading a future it is likely that the market maker will require the simultaneous trading of a dividend future. This ensures that neither party to the transaction will lose out due to the incorrect estimation of a dividend. Clients can accordingly benefit from share price movements but will neither benefit nor lose due to incorrect dividend estimations. What are the costs? There are a few nominal costs involved in trading a futures contract. Ancillary fees entail the commissions charged by the market maker and the client s broker, along with the booking and clearing fees charged by the exchange and the clearing house.

8 Contact details Investec Equities Richard Swain Telephone (011) (021) Web Investec Securities Proprietary Limited 1972/8905/07. Member of the JSE Equity, Equity Derivatives, Currency Derivatives, Bond Derivatives and Interest Rate Derivatives markets. An authorised financial services provider No A registered credit provider registration number NCRCP262 Confidentiality This communication is confidential and may not be disclosed to any third party without the written consent of Investec. Disclaimer The information contained in this material is proprietary to Investec and is disclosed to you for the sole purpose of considering your investment in the product and for no other purpose. This material is for your information purposes only. It does not constitute an offer, advertisement or solicitation for investment, financial or banking services. It is not intended to constitute advice in any form, including, but not limited to investment, accounting, and tax, legal or regulatory advice. The information, therefore, has no regard to your specific investment objectives, financial situation or particular needs. It is recommended that you consult your financial advisor for assessment of suitability to your unique circumstances. The material is based upon information that we consider reliable as at the date hereof, but we do not represent that it is accurate or complete, and it should not be relied upon as such. All illustrations, forecasts or hypothetical data are for illustrative purposes only and are not guaranteed. The sender accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this communication. Prospective investors should be fully aware of the risks involved in dealing in financial products.