November 28, 2018
Savvy investors can multiply potential gains by capitalising on the leverage effect offered by derivatives, regardless of market movement.
While equities tend to be the vehicle of choice among many investors, derivatives have yet to see widespread uptake in Malaysia.
In fact, Bursa Malaysia Derivatives (BMD) Bhd estimates that domestic institutions and retail investors comprise just 44% of activity in Malaysian derivatives market.
Foreign institutions make up a larger share, highlighting the segment’s international appeal. But what are derivatives and why are they seeing such interest?
In laymen’s terms, derivatives are financial instruments which derive their value from something else, such as stocks, commodities, currencies, interest rates and even weather data.
The prime value they offer to investors is leverage, multiplying potential gains (though this applies to losses as well).
In addition, derivatives traders can accrue returns through short positioning, making a profit in both bullish and bearish market trends.
Three categories of derivatives are currently offered by BMD in Malaysia, namely commodity, equity and financial derivatives.
Commodity derivatives draw their value from agriculture products and precious metals such as crude palm oil and gold. Crude palm oil futures are one of the most popular derivatives currently being traded in Malaysia.
Meanwhile, equity derivatives such as the BMD FM70 draw their value from the FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI), with single stock futures contracts based on selected counters.
Finally, financial derivatives are based on short-term interest rate instruments traded in the money market, as well as bonds, including three-, five- and 10-year government securities futures.
However, financial derivatives account for the least trading activity in the Malaysian exchange due to the stability of domestic interest rates.
In general, derivatives come in four flavours. Futures contracts are agreements to buy and sell assets in the future, while options are similar but carry no obligation to complete the transaction, just the right.
Meanwhile, swap contracts are agreements to exchange cash flows for a time, and forward contracts are like futures contracts, but are held between private parties instead of exchange-traded.
Regardless of type or underlying asset, derivatives offer the potential to multiply returns through leverage. Leverage, in laymen’s terms, is the control of a larger investment through a small amount of capital.
For example, the value of a BMD FM70 contract is equal to the index points of the FBM Mid 70 multiplied by RM2. If the FBM Mid 70 is at 15,000 points, the contract is worth RM30,000.
Each movement of the FBM Mid 70 index is thus multiplied, so if it goes up by 120 points, the trader will earn RM240, or 30% of his initial margin, minus associated fees. Unfortunately, this applies to losses as well.
Thankfully, derivatives also give traders the flexibility of taking a short position on a contract to profit from downwards market movements.
This is because derivatives traders can agree to sell something in the future without owning it first, whereas stock traders must typically buy a stock before selling it.
In the example above, a trader could sell an FM70 contract with the FBM Mid 70 at 15,476 points, then buy another when the index falls to 14,702. In this scenario, his profit would be RM1,548, minus associated fees.
Through prudent use of leverage and short positioning, investors can utilise derivatives to maximise the profit potential from modest initial capital.
The article is contributed by Aliff Yusri from Smart Investor. Smart Investor is the country’s leading monthly investment magazine. It focuses on enhancing value for both retail and institutional investors via its extensive corporate and financial commentaries and features.
Disclaimer: The views expressed in this article are those of the author and do not necessarily reflect those of CompareHero.my