Stock futures cheap ticket to huge gains and big losses

Sean Kennedy

THE key difference between stock futures and options is in the risk to the investor. While option traders can lose only the amount needed to buy the option, futures traders can lose everything.

If the underlying stock moves dramatically, investors may face huge, unlimited liabilities.

Nevertheless, professional investors have welcomed the introduction of individual stock futures, saying they will help make managing stock positions easier.

Until now warrants and over-the-counter options were the only avenues open to investors who wanted the leverage which derivative products offered.

Initially, contracts will be offered on HSBC Holdings, which accounts for 14 per cent of the Hang Seng Index, and Hongkong Telecom, which accounts for 10.5 per cent.

The new stock futures contracts will be used mostly by more sophisticated investors who want to either hedge an existing position or gain exposure to a stock without having to actually buy it.

In that respect, they are similar to covered warrants.

The main difference for professional investors is that stock futures allow net selling, which is effectively short-selling, while warrants do not.

Another key difference is that warrants can convert to the underlying stock, while futures have a final cash value.

A third difference is that warrants either expire in-the-money, which means they can convert into shares, or out-of-the-money and are worthless.

Stock futures have a value either way, and are in effect a zero-sum game.

Covered warrants also tend to be longer dated, usually 18 months or two years, while stock futures have a life-span of as short as three months.

As with the Hang Seng Index (HSI) futures contracts launched in 1986, stock future contracts work in multiples, with potentially massive gains but potentially gargantuan losses.

A rise of 10 per cent doubles earnings, but a fall of only five per cent can eliminate the investor's stake.

Assuming an investor buys a stock future contract in HSBC when the share price is $100, and when the margin is a hypothetical five per cent. The futures exchange is still working at establishing margins.

The contract is now worth $200,000, but the investor needs only $10,000, or five per cent of the contract.

The investor's stake is arrived at by multiplying the share price of $100 by 2,000.

If the underlying share price rises by 10 per cent to $110, the investor's contract is now worth $220,000, a profit of 100 per cent on the $10,000 outlay.

If the underlying share price falls five per cent to $95, the value of the contract is $190,000, which means the investor's $10,000 is wiped out, at which point the decision has to be made whether to add more cash or close out the position.

The low initial investment is attractive, and investors have warmed to the derivatives.

In Australia, where stock futures began trading this year, the main users of the instruments are professional investors rather than individuals. This is in strong contrast to covered warrants which have proved a hit with retail investors in Hong Kong.

Whether the new contracts will prove as popular with local investors remains to be seen, but certainly they are likely to be cheaper in terms of implied volatility than covered warrants, which could attract converts.

The futures exchange has not yet finalised how the new contracts will be traded, but brokers are already talking about market makers trading two-way prices in the contracts as they do in other overseas markets.

This would be a good move as it would greatly increase liquidity in the market and make trading in the underlying stock more efficient by having better prices quoted in the futures market.

Meanwhile, volumes on the futures exchange have surged. As at October 21, the trading volumes in HSI futures and options stood at 3.26 million lots and 461,739 lots respectively.

Futures exchange chief executive Ivers Riley said trading volumes yesterday hit a record for a single day of 42,366, surpassing the post-1987 crash record of 40,147 lots.

'Today's record turnover is a significant milestone for the exchange,' he said. 'With the introduction of our new stock futures in the near future, it will further confirm the importance of Hong Kong as a major financial centre.'