The Next Big Thing
Individual Share Futures Examined

There is a Financial Product trading quietly at the moment, just waiting to be discovered by the investment community. It is futures contracts on a parcel of shares in any one of the top twenty stocks on the Australian Stock Exchange. These contracts are called Individual Share Futures (ISF's) and are traded on the electronic trading platform of the Sydney Futures Exchange, much the same way as the shares themselves are traded on the ASX platform SEATS. As a share investor or trader you may not know much about Futures. I hope that the enormous potential in this product will soon become apparent as I explain them fully.

Firstly, what actually is a Futures Contract?

It is really quite simple. A futures contract is a contract to buy or sell something. In this case it is a parcel of 1,000 shares in one of the big companies, let's say BHP. The delivery date on the contract is set at some time in the future, but the price is fixed now. Very simple, but from this simple concept has grown a very powerful investment vehicle. Traders open an account with a futures broker and they can either deal in the contacts directly from their computer or over the phone. An active share trader will find many advantages in trading these contracts. Let's look at a few of them.

Get a Little Leverage in Your Life

Every investor knows what leverage or gearing is and most realise that you need a certain degree of it to really make good returns. Leverage enables you to control the full value of an asset without having to pay for it completely. You normally put up some proportion of the asset's value and borrow the rest. If you want to buy 1,000 BHP share at $10.00 a margin lending account will lend you 60 per cent of the value of the shares and so you put down $4,000 and borrow $6,000 to own the shares. You pay interest on the $6,000 you have borrowed and get any dividends payed by the company. If the price of the shares goes up to, say $11.00, you make the full paper profit of $1,000. This equates to a 10 per cent gain in the share price but a 25 per cent gain for you, since you only paid $4,000. Let's say after a month you sell out and take the profit.

If you buy a BHP Share Futures Contact for the same 1,000 BHP shares at $10.00 you don't actually own them but rather you have agreed to take delivery of them and pay the full price at a set date in the future. You have to lodge a security deposit, called a 'margin', of $775. You pay no interest on the remaining $9,225 of value of the shares. If the price goes up to $11.00 you can then sell your Futures Contract at that price and you earn a $1,000 profit that represents a 129 per cent gain. Obviously increased leverage is a powerful tool but it should be used wisely as it can also create a larger percentage loss if the shares go down.

 

Liquidity

Another major factor in favour of the futures markets is that generally they are very liquid. This means they have a high volume of trades and so it is always easy to get in or out in an instant. Normally if you have relatively limited funds and wish to trade shares you find yourself at the small end of the market. You are typically limited to companies whose shares are trading in the 10 cent to 50 cent range. While these shares can show good movement they are typically rather thinly traded. This lack of liquidity means that you may get caught in a situation where it costs you a couple of cents movement in the share price just to get out.

 

What Happens if the Market Falls

Let's say that instead of going up to $10.00 the price of BHP shares actually falls to $9.00. If you bought you would be showing a loss, but perhaps you may have correctly anticipated the drop. This will illustrate one of the real advantages of using ISF's to trade the big stocks.

I said earlier that a Futures Contract is a contract to buy or sell. You can enter a contract to sell the shares and deliver them in the future at a price agreed on today. Obviously if you think the price is going down and so it is too expensive today you can take a contract to sell at today's high price. Of course if you still have the contract open you will have to deliver the shares on the day and be paid the full price of the contract, not the market price on the day. So you could buy the shares at the prevailing market price of $9.00 and then deliver them and be paid the $10.00 thus making $1,000 profit on the falling price. In practice you simply buy back the contract at $9.00 and make the same profit. Of course if BHP goes up to $11.00 you would buy back your contract at a $1,000 loss.

When you enter a contract to sell in the future, it is called going 'short'. Entering a contract to buy is called going 'long'. It is equally easy to do either.

The ability to go short is a key concept in futures trading When trading the shares themselves, going short is a lot harder than buying since the broker has to lend you the shares. Some brokers either actively discourage the practice or simply don't do it. This has the effect of locking the share trader into being a bull and always looking for the market to go up, and we know that just doesn't happen. There is an old saying that the market goes up by the stairs and down by the elevator. Short trades often happen a lot more quickly than long ones. We are now starting to talk like a futures trader and so here is something that all traders love to hear:

 

Low Transaction Costs

Buying and selling $10,000 worth of BHP on the futures market will cost you $21.50 brokerage in and the same to get out, plus GST and with no Stamp Duty. This equates to a very low 0.215 per cent, which isn't bad at all.

 

Movers and Shakers

Another problem an active trader may face is when you buy a particular share and it just goes to sleep. This can be frustrating and if you have bought options, either puts or calls, it can cost your real money, as you watch the time decay bleed value from the option's premium. This rarely happens when you trade ISF's because the shares they cover are the movers and shakers of the Australian Stock Exchange. They are the large capitalisation stocks and provide a great trading medium because they are volatile and thus provide opportunities on the long and short side of the market. They can be too expensive to be traded outright by many investors but using Individual Share Futures give the leverage to trade them in meaningful quantities.

In the next issue I will discuss strategies to use Individual Share Futures for trading and for protecting your portfolio against a market fall.

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