History shows that the best asset class to invest in over a period of time is equities. Shares have outperformed cash, bonds and property over the longer-term and will in all likelihood continue to do so in the future. Despite the long-term nature of s
We refer specifically to option and derivative products which allow consumers to take positions regardless of the expected direction of the market. Used sensibly, such products can magnify returns and provide protection for portfolios when markets turn.
Unfortunately the flip-side of the coin is that speculators can suffer serious losses if they get their strategies wrong. To better understand these investment products we need to familiarise ourselves with the concept of gearing.
A simple example of gearing
When early man first struggled to move large obstacles, he soon discovered that he could impart a greater force on an object by using a combination of a small boulder and a long stick or lever. The concept of leverage involves taking a small input and magnifying its output. Similarly, we soon learned that through a series of gears or pulleys we could lift larger weights or generate greater speeds. We thus have two terms, gearing and leverage, with similar meanings.
Financial leverage simply involves maximising exposure to the market with the minimum financial input. A mortgage bond is an easy-to-understand example of financial leverage. You could, for instance, gain control over an asset worth a million rand with a small deposit of R100, 000. Your capital outlay secures influence over a much larger amount. If house prices rise by 10% your asset is worth R100, 000 more. You have thus 'made' a 100% return on the R100, 000 deposit you put down on the house Or put another way, your R100, 000 deposit is geared 10 times!
Financial leverage (or gearing) is quite common in stock markets around the world. Most options and derivative products include an element of gearing, allowing investors to take a significantly higher stake in an asset than they could otherwise afford.
The ultimate 'geared' investment
South African investors can trade single stock futures through the JSE. A single stock future is a derivative product whose price is based (or derived from) the price of an ordinary share trading on the JSE. Each single stock futures contract gives an investor exposure to 100 ordinary shares. So, for instance, if you purchase one Standard Bank single stock future, you will effectively control 100 Standard Bank shares.
Let us consider a simple example to demonstrate the gearing or leverage involved in a single stock futures trade.
An investor decides that the banking sector is in for another significant run. He completes his analysis and decides that he likes Standard Bank at R108 per share and can afford to buy 1, 000 shares. In a conventional share trade, he would purchase these shares on the JSE at a total cost, excluding brokerage, of R108, 000.
With single stock futures, he can simply purchase 10 futures contracts at a price of R1, 500 per contract, or R15, 000. His single stock future investment provides 'exposure' to the same number of Standard Bank shares as the R108, 000 ordinary share purchase described earlier. He has effectively geared his R15, 000 by 7.2 times.
In layman's terms, and excluding the impact of trading costs, this investor will realise a 7.2% increase in his R15, 000 for every 1% increase in the Standard Bank share price. The big problem is that if he gets it wrong, and the price of Standard Bank falls, he will lose 7.2% of his R15, 000 for every 1% fall in the share price.
World's largest Single Stock Futures market
South Africa's single stock futures market is still in its infancy. Yet the 2007 World Federation of Exchanges Report on derivatives markets shows that South Africa's Single Stock Futures market has overtaken India as the largest in the world. Allan Thomson, director of trading at the JSE is extremely pleased with developments. "Taking into account that the JSE really got this market off the ground only six years ago, this is an achievement which we can be justifiably proud of," he said.
In an unbelievable first quarter South African investors traded 44 million contracts. This is some margin larger than India's National Stock Exchange, which recorded only 30 million contracts in the similar period. It certainly seems that the retail investor enjoys the gearing effect offered by this product and is not shy to use it to his advantage.
One of the biggest mistakes made by new investors when entering a geared trade is that of incorrect position sizing. The prudent rule is not to invest more than 10% of your available capital in a geared trade... While many argue that this conservative practice subverts the benefits of geared trading, it is financial suicide to use 100% of available funds in a geared trade!
Editor's thoughts:
Single stock futures offer the entry level investor an opportunity to employ trading strategies that used to be the exclusive domain of professional investors. This means they not only have the opportunity to make huge profits; but risk making huge losses too. Do you think that an entry level investor should be trading futures for his own account? Send your comments to gareth.stokes@fanews.co.za
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