Kenanga Deutsche Futures : Futures 101 (Series 3)

Series 3

Characteristics of Futures Market

 

Initial Margin

  • In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities.
  • In the futures market, margin is the initial deposit made into an account in order to enter into a futures contract. This margin is the money that is used to debit any day-to-day fluctuations.
  • When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract.
  • In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.
  • Let's say that you had to deposit an initial margin of RM 4,000 for FBMKLCI futures (FKLI) contract, a series of price fluctuations reduced the value of your account to RM 3,000. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional RM 1,000 to bring the account back up to the initial margin level of RM 4,000.
  • When a margin call is made, the funds usually have to be delivered immediately or within the agreed period. If they are not, the broker has the right to liquidate your position completely in order to make up for any shortfall it may have incurred on your behalf.
  • Futures positions are highly leveraged because the initial margins that are set by the exchange are relatively small compared to the cash value of the contracts in question. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of RM 4,000, you may be able to enter into a long position in a FKLI futures contract valued at RM 80,000, which would be considered highly leveraged investments.
  • The futures market can be extremely risky and, therefore, not for the faint hearted. Highly leveraged investments can produce two results: great profits or great losses. As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit.
  • For example, say that in anticipation of a rise in stock prices across the board, you buy a FKLI futures contract with a margin deposit of RM 4,000, for an index currently standing at 1,600. The value of the contract is worth RM 50 times the index (e.g. RM 50x1600=RM 80,000), meaning that for every point gain or loss, RM 50 will be gained or lost.

Ticks

  • However, prices on futures contracts have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as "ticks". For example, the minimum sum that a FBMKLCI index can move upwards or downwards is 0.5. For futures investors, it's important to understand how the minimum price movement for each commodity will affect the size of the contract in question.

 

Price Limit & Position Limit

  • Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day. Futures trading shuts down if prices reach their daily limits, there may be occasions when it is not possible to liquidate an existing futures position at will.
  • The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or "spot" month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.
  • In order to avoid any unfair advantages, SC and Bursa Malaysia Derivatives impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.