Investors concerned about the slowing economy and an imminent downward cycle have started looking for ways to protect their equity investments. Futures contracts can be an effective hedging tool in such a scenario, says Choong Ty’ng Ty’ng, founder and managing director of investor education provider Axcelearn Sdn Bhd.
“Our economic cycle is on the verge of a downturn. So, if you are holding stocks, you would probably want to reduce your exposure and either hold more cash or venture into futures contracts,” she says.
“With the right timing, you could hedge against the market if you do not want to sell your stocks. And if you think there will be a major downward trend, you could take more risk and speculate on that trend.”
This needs to be done with a trading and risk management strategy in mind, she adds. “No one can accurately predict how many points the market will fall when it goes on a downward trend. But historically, every time there is one, the Malaysian market suffers more than 45%.
“So, if you are holding stocks and the market retraces, you can prepare for it by hedging [with futures]. However, many people prefer to sell their holdings or hide and not look at the market.”
Choong was head of futures dealing at AmFutures and subsequently head of e-broking advisory at AmInvestment Bank Bhd about five years ago. Over the past two years, she has been educating the public on futures trading through a series of Bursa Malaysia Derivatives workshops. She has also written a guide to trading in the Malaysian futures market called Jumpstart in Stocks and Futures Trading.
Traders can use a number of strategies in today’s market. This includes hedging, which is similar to buying insurance for one’s investments, says Choong.
“The key to trading is to generate consistent profits. But sometimes, your portfolio is affected by economic cycles. If the market retraces and you are holding stocks, you will suffer losses,” she points out.
“However, you can short futures to compensate for your losses. Hedging is not meant to make you money, but to protect your stock portfolio. I always encourage people to learn futures trading, even if they do not want to engage in speculation, because it gives them the opportunity to hedge their portfolios.”
This strategy is increasingly used by traders, especially in the current market conditions. For instance, last year’s market volatility boosted the 4Q2018 revenue of CME Group, one of the biggest derivative exchanges in the US. According to reports, trading in its equity and interest-rate contracts saw the most growth due to the significant volatility in equity markets and speculation on rising interest rates last year.
Similarly, the Australian Securities Exchange’s net profit was up for the six months ended Dec 31, 2018. Reports pointed out that market volatility had contributed to a 5% rise in the number of futures contracts traded, particularly the Australian SPI equity futures and electricity contracts.
Even in Singapore, hedging activity using derivatives is expected to increase in the months ahead, driven by anticipated volatility in its underlying markets, which are the equity and interest-rate markets, according to a recent report by The Edge Singapore. Geopolitical uncertainty is prompting investors to park their money in derivative instruments to hedge their investments.
Choong illustrates how investors can use futures contracts to hedge their positions. She says if an investor anticipates that the local market will drop to 1,650 points, from 1,750 points currently, due to an adverse event, he can short the futures contract of the index — the FTSE Bursa Malaysia KLCI Futures (FKLI) — to hedge against losses.
“Let’s say you buy the FKLI contract to close your position. If the market falls to 1,650 points, you can make a profit of 100 points. For every point, the gross profit is RM50 (the contract size set by Bursa Malaysia Derivatives for the FKLI). So, you make RM5,000 on this contract. This would allow you to break even if your stock portfolio suffers a loss of RM5,000,” says Choong.
However, the portfolios of some investors may be too small to hedge with futures contracts. You would only use a futures contract to hedge if the total value of your portfolio is equivalent or more than the per contract value of the futures product, she says. “For example, the FBM KLCI is trading at 1,750 points. Multiply that by RM50 to get the contract size of the FKLI. This will give you a contract value of RM87,500.”
In this case, you would only use the FKLI to hedge if your portfolio is larger than RM87,500 — the current equivalent of one futures contract. “Another option is to use the Mini FTSE Bursa Malaysia Mid 70 Index Futures (FM70), which has a smaller contract size [multiply the index by RM2],” says Choong.
But if your portfolio is smaller than the contract value, it would make more sense to just sell the stocks to avoid further losses, she adds. “Hedging is more for those with bigger portfolios who cannot take the risk or those who have long-term investments and need futures contracts to hedge against temporary volatility. This is not really a guideline or benchmark, but you can always take the contract size set by Bursa to determine if you should hedge.”
Some traders use futures contracts for speculation or arbitrage. In this case, market volatility can work to the advantage of those looking to generate returns using these strategies.
Speculators take large risks by anticipating future price movements in the hope of making large gains while arbitrageurs attempt to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing “risk-free” profits, according to Bursa.
In the soft commodity space, there could be arbitrage opportunities between crude palm oil futures (FCPO) and those of soybean oil, for instance. If the FCPO is cheaper than the soybean oil futures contract, there will be more demand for crude palm oil. So, one can make a return by shorting soybean oil futures.
Choong points out that the FCPO is more volatile than the FKLI, which makes it popular among traders using strategies such as arbitrage.
Arbitrage can also be done when there is a price difference between the derivative and the underlying asset. For instance, sometimes the FBM KLCI trades at levels below the FKLI and vice versa. On the other hand, the premium and discount between the FKLI and FBM KLCI can be useful for gauging the sentiment of traders. “For example, if the FKLI is at a discount most of the time, it means the traders’ forecast is not so positive,” says Choong.
There are three types of products traded on Bursa Malaysia Derivatives: Commodity, financial and equity derivatives. Commodity derivatives include futures contracts for crude palm oil, crude palm kernel oil, palm olein, gold and tin, some of which are denominated in US dollars. Financial derivatives include the futures contracts of the 3, 5 and 10-year Malaysian Government Securities (MGS) and the 3-month Kuala Lumpur Interbank Offered Rate.
Equity derivatives include the FKLI, single stock futures (SSF) and the FM70, which was launched last August. Some of the products, such as the MGS futures, require a transaction size of at least RM100,000 while SSF trading is limited to 10 blue-chip stocks. Each SSF is equivalent to 1,000 shares of the underlying asset.
According to Bursa data for the six months ended December 2018, the FCPO saw the biggest trading volume over the period (more than 731,180 contracts), followed by the FKLI (more than 176,464 contracts). Meanwhile, the FM70 saw its monthly trading volume rise from 4,518 contracts in August last year to 68,405 in December.
“Technically, so long as the product has enough volume and retail traders can afford the initial margin, they can go in. The common ones in Malaysia [for retail traders] are the FKLI and FCPO, followed by gold futures and the FM70. Some products are mainly accessed by institutional clients. But as long as the margin is somewhat equivalent to that of the FCPO and FKLI, I think retail traders can afford it,” says Choong.
However, some futures contracts have seen low trading volume. Of the 13 futures contracts offered by Bursa Malaysia Derivatives (excluding options contracts), only five saw trading activity in the second half of last year. Of the five, gold futures had the lowest monthly trading volume of less than 60 contracts.
Interestingly, slightly less than two-thirds of the trades were made by retail investors (58%) while institutional investors made the other 42%. For other types of futures contracts in the local market, institutional investors were the main drivers of trading activity.
Futures not just for sophisticated traders
Choong argues that futures contracts are not something that only traders with deep experience in the stock market can participate in. The barrier to entry is similar to that of the stock market, she points out, especially after Bursa launched the FM70 mini contracts targeting retail investors last year. The initial margin of the FKLI and FCPO is RM4,000 while that of the FM70 is only RM900.
“For futures, the only thing is that you need to prepare slightly more funds than the initial margin to kick-start your trading. I usually ask people to double their margin barriers. For instance, it is currently about RM8,000 for the FKLI and RM1,800 for the FM70,” says Choong.
This is done to provide a buffer against extreme market conditions.
Futures contracts are a good way for investors to learn trading because they will learn hard lessons fast, she says. “When you start with futures, you have the advantage of learning fast because with stocks, you only learn when the market crashes. But trading futures could really test you because you could even suffer losses in a single day. If you learn from these lessons, you will grow very fast.”
Choong makes a comparison between owning a stock and holding a futures contract that is decreasing in value. Stocks traders tend to hold on to their shares even when their value is decreasing because they hope that the stocks will rebound and make money, she observes.
“But for futures, many traders are kicked out of the market the moment they do not have the money to top up their accounts when they fall below the margin required [to maintain the contract],” she says.
Margins are considered a deposit to cover potential losses due to market movements. If there is a negative return on any futures positions, the trader may need to add some funds to return to the maintenance margin requirement. This forces them to face reality, says Choong.
“Stocks allow you to hide your head in the sand. But futures trading will teach you very good lessons. If you ask me, I think learning to trade with futures is a good thing because it really exposes you to what trading and investments mean,” she adds.
Through Choong’s interactions with the participants of Bursa’s futures workshops, she has observed that many Malaysians do not understand these derivatives. Some see futures trading as a gambling activity because it only involves buying and selling instead of holding, as one does when investing in stocks. Movies add to the misinformation by portraying futures trading as a dramatic and high-risk betting exercise.
“If you can understand the basic terminology of futures trading, they can be easier to trade than stocks. In Malaysia, we have more than 1,700 stocks and warrants. But for futures, retail investors can technically only [afford to] trade two or three products. So, in terms of analysis, it is less,” says Choong.
“When you go for equity investments, you need to do analysis on macroeconomics, the industry and individual stocks. For futures contracts in Malaysia, you only need to do macro analysis.”
Many Malaysians lose money trading futures because they do not manage their risk properly or have not learnt proper trading strategies, she says. “You must learn before going into the market. Many people learn about futures trading from their friends, who find it easy to buy and sell but lose a lot of money over that. Then, they tell their friends to stay away from futures trading because of the high risk. The problem is that they did not learn [the proper strategies].
“Risks can be managed. It is just that many retail traders do not do so.”
A very important part of futures trading is knowing how to limit losses. That is why Choong emphasises that traders must learn risk management before they even start trading. They should understand their investing preferences and discover whether they are more suitable for intra-day trading, which requires close attention to the market on a daily basis, or longer-term trading.
Putting in stop orders is a must, says Choong. “If you ask me why many people suffer losses, it is because they drag too long and keep topping up their margins without a limit.”
Other risks investors should pay attention to are gap openings. This refers to the difference in price at which the market opens and closes on consecutive days, which poses a risk to futures traders who hold their positions for more than a day.
“Within a day, you can be 100 points richer or poorer, for example. Some people want to avoid this and go for intra-day trading. But it may not be the correct thing to do with certain products in illiquid markets,” says Choong.
She also advises retail traders to start trading futures contracts in the Malaysian market due to their familiarity with local products. “Many retail investors do not know the risks and start by trading Hong Kong futures, for example. Those are even more volatile than the futures in the local market,” she says.
“Even if you start in Malaysia, you need to know what products are suitable for you. Many start with the FCPO, but it is very volatile and high risk for retail investors. So, maybe they should start with the FKLI as they are already familiar with the FBM KLCI.”
The making of a trainer
Choong Ty’ng Ty’ng, founder and managing director of Axcelearn Sdn Bhd, graduated with a bachelor’s degree in accounting from the University of Malaya, but she did not want to pursue a career in that field. So, she explored her other options.
In the end, she chose a position that interested her even though it was not a high-paying one — a futures dealer at AmInvestment Bank Bhd — where she learnt everything about the derivative instrument. “When I started, it was early 2007. By the middle of that year, the market had become very volatile even though it was still on an upward trend. Subsequently, we suffered a retracement in 2008. That was when I really learnt lessons because I had never seen the market go up and down more than 200 points within seconds,” says the 37-year-old.
At the time, people were either losing or making a lot of money. She saw many traders suffer from “over loss”. “Futures is a contract. You do not need to pay anything other than the margin when you go in. For instance, right now, one FKLI contract costs RM4,000. Every point is worth RM50. Technically, if the market moves more than 80 points [against you], you lose the RM4,000,” she says.
“If the market moves against you by 100 points, the loss is RM5,000. But your deposit is only RM4,000. The RM1,000 difference is what we call over loss.”
Choong recalls that her team was given instructions to not execute any market orders, or those that are executed using the best price available in the market without specifying a designated price. “Let’s say you execute 500 contracts at once. If you execute these contracts when the market is not volatile, you will roughly know the average price you will get,” she says.
“But in volatile times, if you execute a market order, the price may be RM300 or RM400 [more than the previous price] and you would immediately incur a loss. This was an eye-opener to me.”
After five years, Choong was promoted to head of futures dealing. She held this position for two years before doing a two-year stint in the e-broking advisory division. She then resigned and spent about six months volunteering before becoming a licensed trainer and providing Continuous Professional Education courses for fund managers, research analysts, remisiers, futures brokers and the public.
Choong has conducted Bursa Malaysia roadshows for two years. During this time, she ran about 40 workshops a year on average for adults as well as courses for university students.
“The Bursa Malaysia Derivatives workshop covers three topics — futures basics, trading plans and risk management. In the morning, we provide sessions on trading theories. In the afternoon, participants go through a simulation,” says Choong.
“Axcelearn is the first in the industry to do that. Whatever you learn in the morning, you apply it in the afternoon on a platform that imitates 90% of how the actual platform works. This allows participants to understand what they were taught in the morning.”
Futures trading is a common strategy among traders in many countries. Choong wants to provide more education on this topic in Malaysia.
“We want to give people another option. Every product has its advantages and disadvantages. During an upward trend, stocks have an advantage because you can make money. But during a major downward trend, you cannot make money from the stocks themselves. So, futures trading can offer you another alternative to gain returns,” she says.
Choong plans to offer futures trading courses for intermediate and advanced traders through Axcelearn this year. “We will provide more intermediate to advanced courses. This includes, but is not limited to, trading systems, backtesting and position sizing.”