What are futures?
- A futures contract is a type of derivative instrument. It is a financial contract, where two parties agree to transact a set of
financial instrumentsor physical commodities for future delivery at a particular price.
- The value of a futures contract is derived from the value of an underlying asset. For example, the value of Crude Palm Oil Futures (FCPO) is derived from the value of crude palm oil itself.
- Buyers and sellers primarily enter into futures contracts to hedge risk or speculate on the price movements. This is why futures are used by producers, consumers and speculators.
- Futures contracts are traded on regulated exchanges with specific quantity, quality and time duration.
It might surprise you that investing in futures contracts can build and protect your wealth.
The FKLI is a more efficient way to gain quick exposure to the Malaysian stock market as it involves trading one contract only and thus, has effectively eliminated the need of making multiple transactions.
I have always been a proponent of investing in stocks and properties. Recently, as I got to understand futures trading a little better, I realised that this form of investment can also effectively help to build and protect wealth.
In this article, I’ll use the FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI) to share five key reasons why you might want to start considering it. FKLI isan equity index futures contract with FTSE Bursa Malaysia KLCI as its underlying asset i.e. the capitalisation-weighted index of top 30 blue-chip stocks of Bursa Malaysia.
What is the most efficient method to begin investing or trading shares of every 30 largest stocks listed on Bursa Malaysia?
Is it to enter the stock market and buy shares in all of these stocks? Technically speaking, you can do so if you have a huge capital – by making a total of 30 separate transactions to gain exposure to all 30 largest stocks listed on Bursa Malaysia.
That’s too much of a hassle.
Instead, I think the FKLI, which is a futures contract derived from the FTSE Bursa Malaysia KLCI, is a more efficient way to gain quick exposure to the Malaysian stock market. It involves trading one contract only and thus, has effectively eliminated the need of making multiple transactions. Of course, there are other ways such as index funds and ETF, but this leads us to:
If you opt to buy shares in all 30 largest stocks, how much does it cost to buy a minimum of 100 shares in these 30 stocks?
As stated above, you would invest RM955 in Maybank plus RM2,498 in Public Bank, and the rest of the blue-chip stocks that made up the KLCI. (*price based on date of writing)
Suffice to say, the amount is enough for a down payment of a piece of property in Kuala Lumpur, and that is not including the stocks’ brokerage fees and stamp duties.
Instead, the FKLI offers traders an opportunity to have a position in the KLCI by placing a small deposit known as margins. At the point of writing, the KLCI is trading at 1,729 index points. Hence, the contract size for the FKLI is RM86,450 as it is calculated by multiplying the KLCI’s index points with RM50.
Instead of RM86,450, traders would place an initial margin of RM4,000 to gain exposure in the KLCI. Traders get leverage as their cash upfront is just a mere fraction of the total contract size of the KLCI.
So, it leads us to:
#3: Bigger Returns
Consider these options:
Option 1 – You invested RM 86,450 into a stock portfolio.
Option 2 – You placed RM 4,000 to buy one contract of FKLI worth RM86,450.
If the stock portfolio and the KLCI had appreciated by 5%,
Option 1 – The value of your stock portfolio increased to RM90,772.50, an addition of RM4,322.50. Congratulations!
Option 2 – As stated above, if the KLCI at 1,729 has risen by 5% to 1,815 index points, an addition of 86 index points, it is worth RM4,300 in profit as an index point is worth RM50. As you placed RM4,000 to execute the trade, your total return on this trade is 107.5% (RM4,300/RM4,000 x 100%) despite the KLCI increasing at a quantum of 5%.
#4: Profit from a Downturn
Imagine the following scenario.
The local stock market sentiment is bad and you expect the stock market to fall in the short-term. What can you do if you are a:
Stock Investor – You can choose to sell your shares or hold onto them.
Futures Trader – You can choose to ‘short’ or sell the FKLI to profit from its fall. Once again, the KLCI is trading at 1,729 index points today. This time, you think that it would fall to a lower level, let’s say, 1,700 index points. Here is what you can do as a futures trader:
First, you sell the FKLI at 1,729 index points. Next, if it drops to 1,700, then, you close your position by buying the FKLI at 1,700 index point. You stand to gain 29 index points or RM1,450 from this trade. Hence, a futures contract allows traders to profit from both market directions – upwards and downwards which is unlike stocks. Thus, it leads us to:
You are an investor who manages a stock portfolio worth RM1mil. From it, you are receiving a dividend yield of 5% or RM50,000 in dividend income every year. If you believe that the local stock market sentiment is bad and may negatively impact the market value of your stock portfolio, what can you do?
Supposedly, you believe the KLCI could potentially drop by 5% in the following few months and, as a result, may cause the value of your stock portfolio to fall by 5% – effectively wiping out your dividend income of RM50,000.
Hence, you decided to short ten contracts of the FKLI. The initial margin for one contract is RM4,000. The KLCI is trading at 1,729 index points, and real enough, it fell by 5% to 1,643 index points. It is a drop of 127 index points, and thus, you gained RM6,350 for each contract. As you shorted 10 FKLI contracts, your total gains for these trades are RM63,500.
In the meantime, your stock portfolio had fallen in value by 5% to RM950,000 from RM1mil. It lost RM50,000 in value. Thus, you could use the gains of RM63,500 from shorting the FKLI to offset the value fall of RM50,000 in your stock portfolio. As such, you have ‘hedged’ or protected your portfolio from a potential fall in the stock market.
For sophisticated investors with substantial capital, hedging is like buying insurance. Your gain is secured!
A word of caution though, this may not be an investment tool for the faint hearted. Without the right knowledge and experience, trading futures can wipe out most of your capital.
ABOUT THE AUTHOR
KCLau is a financial educator. He had published 6 books and co-created a dozen online financial courses.
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