This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 25 - 31, 2016.
Futures trading has been traditionally viewed as high risk. But in volatile times such as these, the contracts can be used as a hedging tool. This allows investors to hold on to their investments until the market rebounds, says Straits Index Sdn Bhd director Yong Chen Chook.
Most local investors do not use futures contracts to hedge against the investment risks in their portfolios. However, with volatility being the new normal in financial markets, they should consider doing so, says Straits Index Sdn Bhd director Yong Chen Chook.
“Most local investors put their money in stocks or equity funds. They are able to reap steady returns when the economy and markets are good and healthy. But today, the overall market is bearish and volatile. Companies are not generating profits and earnings per share are suppressed. Stocks are not performing well. In such times, investors tend to get hit and often have to sell some of their holdings to cut their losses and decide when to buy them back later,” he says.
“This is where futures trading, such as gold and index futures, come into play in the current economic environment. Investors can use it as a hedging tool to ride out the short-term market volatility and hold on to their investments until the market rebounds.”
Most local investors do not like the concept of hedging because part of the values of their investment portfolio would go down while the others go up. They tend to overlook the benefits of it. “Most local investors don’t like this idea (referring to hedging). They prefer their investment portfolio to either go up or go down together. But hedging can benefit them. And this could be done through futures trading,” he explains.
Investors will be able to leverage adequately through futures trading, provided they know the risks involved. And the remaining capital, which is freed up through leveraging, can be invested in other asset classes that could be used to enhance investors’ returns, says Yong.
Gold futures
Investors could take a long position on gold futures to hedge against the current global economic downturn and weakening ringgit, says Yong, who is an associate participant of Bursa Malaysia Derivatives and has been trading stocks and futures for more than 15 years.
This is a simple strategy that almost any investor can adopt. Taking a long position means taking a view on where the gold price is headed and investing in gold futures contracts. Investors can expect to profit if the gold price rises, but they will suffer a loss if it falls. On the other hand, investors could take a short position to profit from a fall in the gold price.
“The gold price tends to rise when there is a global economic downturn because the metal is seen as a safe haven — and gold is priced in US dollars. Thus, when the ringgit plunged 20% in the past two years, the currency risk in investors’ portfolio could have been hedged by gold futures contracts,” says Yong.
“However, investors who are thinking of adopting this strategy should take into account the gold price movement itself. It means when the ringgit falls 20%, gold futures contracts gain 20% in terms of currency. But if the gold price falls 5% at the same time, investors gain only 15%.”
There are several advantages to trading gold futures compared with trading physical gold, says Yong. Investors could trade gold at prices 20% lower than the physical gold being sold on the retail market.
That is because the gold price on Bursa Malaysia Derivatives gold futures contracts is not based on the retail market price, but is tagged to the gold price on the COMEX exchange. The metal was trading at US$1,335 per troy ounce on July 12.
Investors who open a futures trading account with a licensed futures broker of Bursa Malaysia Derivatives could trade 100g of gold, worth RM17,200 (as at July 12), on a single gold futures contract by depositing an initial margin of RM1,000 with the broker. This means investors are taking on a leverage of 17 times.
Leverage is another strategy investors can adopt in futures trading. However, Yong says taking on the full leverage of 17 times is extremely risky. He recommends that investors only take on a leverage of 2.4 times and park the rest of their capital elsewhere, such as fixed deposits, stocks and bonds.
“Investors who have RM17,200 can deposit RM7,200 with their broker and put the other RM10,000 into a fixed deposit, stocks or bonds. If they had invested RM7,200 in gold futures [contracts] at the beginning of this year, they would have made RM4,472 as gold [on the COMEX] has appreciated almost 26%. This does not include the returns generated from the other RM10,000,” he says.
Yong prefers to take on leverage of less than 10 times. He says retail investors should assess their investment risk and risk tolerance before leveraging.
“Another thing investors should take note of is that even though Bursa’s gold futures contracts are traded following the COMEX gold price, when the contract expires and it is not rolled over, the gold price will be based on the London Gold Fix price,” he says. The 52-week range for gold prices on the COMEX was US$1,049.40 to US$1,335.50 as at July 12, according to Bloomberg data.
The fees involved in buying gold futures contracts include brokerage and exchange fees that range from RM3 to RM5 for retail investors, while the fees to roll over a futures contract from the current month to another month ranges from RM6 to RM10, according to Yong.
Short Index Futures as a hedge
The FTSE Bursa Malaysia KLCI Futures is another instrument investors can use to hedge against short-term market volatility while holding on to stocks with positive long-term prospects, says Yong.
Two criteria have to be fulfilled for investors to hedge their positions using KLCI futures contracts. First, the stock, or mix of stocks, has to mirror the FBM KLCI’s movements as closely as possible. This also means having a beta of one against the index in financial terms.
Stocks that tend to move in the opposite direction of the index are not suitable candidates. “For instance, exporter stocks and some third-liner stocks are not suitable. This is because [the prices of the] exporter stocks tend to rise when the ringgit and index fall. And third-liner stocks, such as certain penny stocks, tend to fluctuate a lot and do not mirror the movements of the index. Blue-chip stocks [which have a higher weightage on the FBM KLCI] are among those that track the index closely,” says Yong.
Second, the value of an investor’s stock holdings should be equivalent to the value of the KLCI futures contracts. As at July 12, the FBM KLCI stood at 1,654 points. With one index point equivalent to RM50, a single KLCI futures contract had the value of RM82,700 on that day. “Thus, the total value of your stock holdings [which mirrors the index movement as closely as possible,] has to be about RM82,700,” says Yong.
When both criteria are fulfilled, investors can use KLCI futures contracts to hedge their investments against short-term volatility. A case in point is the June 23 Brexit referendum, which sent markets including the FBM KLCI tumbling in a knee-jerk reaction. The local bourse fell 0.61% to 1,629.52 points on June 27. It subsequently recovered to 1,654.08 on June 30.
“Brexit only caused the FBM KLCI to go down for three to four days, but investors were worried when the referendum results came out. Some of them were afraid the market would become bearish in the longer term,” says Yong.
“If you short [sell] the KLCI contract shortly after the market falls, your position is hedged. When the value of your stocks [which tracks the index’s movement] falls by 10%, you would have earned 10% through your contract. And when the market bounces back to the previous level, you can sell your futures contract.
“Basically, you would have hedged your position in the whole event. Investors who did not hedge may have chosen to cut their losses by selling stocks. They may have problems later on when deciding to buy them back. But those who hedged only had to spend some money on the brokerage and exchange fees.”
Yong says the brokerage and exchange fees per contract range from RM12 to RM14 for retail investors, while it costs RM24 to RM28 to roll over the contract.
While futures trading is a useful hedge, he advises caution and that investors must be aware of certain issues. One is that the initial margin for investors to trade a single KLCI futures contract is RM4,500.
Also, an investment position cannot be perfectly hedged as an investor’s stock holdings cannot track the movements of the index perfectly. Investors would also not be able to buy and sell futures contracts at the price they expect in reality.
“We call this (the difference between the expected and exact buying and selling price of the contract) ‘slippage’. But as long as you hedge your position, your losses will be lower than those who did not hedge and preferred to cut their losses,” says Yong.
He says investors can short a limited number of individual stocks under Bursa Malaysia Derivatives Single Stocks Futures (SSF) contracts, but they are not as actively traded as KLCI futures contracts. This creates a challenge for market participants who short individual stocks as they will have difficulty “borrowing stocks” on the market to sell and buy back later.
According to Bursa Malaysia’s website, stocks that can be traded on SSF contracts include Bursa Malaysia Sdn Bhd, AirAsia Bhd, AMMB Holdings Bhd, Berjaya Sports Toto Bhd, Genting Bhd, IOI Corp Bhd, Maxis Communications Bhd, RHB Capital Bhd, Scomi Group Bhd and Telekom Malaysia Bhd.
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