5 solid reasons to venture into futures trading

When venturing into futures trading, go in with your eyes open. (Rawpixel pic)

Futures trading can be used effectively to build and protect wealth. In this article, the FKLI will be used to share five key reasons why you might want to start considering futures trading.

1. Exposure

Here is a question: What is the most efficient method to begin investing or trading shares of the 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 to start with. Here’s the explanation

Today, Maybank is trading at RM9.55 a share. You may buy a minimum of 100 shares in Maybank for RM955. Then, you may proceed with Public Bank, CIMB, RHB, HLB, Genting, Maxis, Digi, TNB and so on.

In the end, you would have made a total of 30 separate transactions to gain exposure to all the 30 largest stocks listed on Bursa Malaysia.

Isn’t it a lot of hassle?

Instead, 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, effectively eliminates the need of making multiple transactions. Of course there are other ways such as index funds and ETFs, but this leads to:

2. Leverage

Let’s assume: You opt to buy shares in all 30 of the 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. Subsequently, you may invest RM2,498 in Public Bank as its stock price is RM24.98. What about other stocks like CIMB, RHB, HLB?

Suffice to say, the amount is enough for you to put as a down payment for a piece of property in Kuala Lumpur. Also, do note there’s brokerage fees and stamp duties for each of these stocks.

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 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. This leads to:

3. Bigger Returns

Option 1: You invested RM86,450 into a stock portfolio.

Option 2: You placed RM4,000 to buy one contract of FKLI worth RM86,450.

If the stock portfolio and the KLCI appreciated by 5%:

Option 1: The value of your stock portfolio increases to RM90,772.50, an addition of RM4,322.50. Congratulations!

Option 2: As stated above, if the KLCI is trading at 1,729 index points and has risen to 1,815 index points, it’s 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 returns 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

Let’s assume: The local stock market sentiment is terrible. You are expecting stocks to fall for the short-term. What can you do if you are a:

Stock Investor: You can sell your shares or hold onto them.

Futures Trader: You can “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 to:

5. Hedging

Imagine this: You are an investor who manages a stock portfolio worth RM1 million. From it, you are receiving a dividend yield of 5% or RM50,000 in dividend income every year.

You believe that the sentiment for local stocks is terrible. As an investor, you are concerned as it may negatively impact the market value of your stock portfolio. So, what can you do?

Suppose you believe, the FKLI could potentially drop by 5% in the following 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 decide to short 10 contracts of the FKLI. The initial margin for one contract is RM4,000.

The KLCI is trading at 1,729 index points and true enough, it falls by 5% to 1,643 index points. It is a drop of 127 index points, and thus, you gain 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 RM1 million. 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 RM 0,000 in your stock portfolio.

As such, you have “hedged” or protected your portfolio from a potential fall in the stock market.

This article first appeared in kclau.com

KC Lau’s first book Top Money Tips for Malaysians has sold thousands of copies. He launched the first online personal finance course specifically designed for Malaysians, entitled the Money Automation System. He also co-founded many other online financial courses including the Bursa Method, Property Method, Founder Method and REIT Method.