30 smart money
THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, JANUARY 22-23, 2011
Investing
with
leverage
A look at how two instruments – extended settlement
contracts and contracts for difference – work.
By Genevieve Cua
I
F you are an experienced investor
looking to invest with leverage,
there are a number of avenues you
can take. This edition of Smart
Money tackles two forms of leveraged trading – extended settlement (ES)
contracts and contracts for difference
(CFD).
There are a number of similarities to
the instruments. Both, for example, require the investor to put up an initial margin, usually in cash and typically at a fraction of the full contract value. It is this feature – a fairly modest initial capital outlay
– that gives the instruments a substantial
degree of leverage which can magnify returns if your view of the market turns out
to be right. But leverage can also hurt you
painfully on the downside if the market
moves against you, causing substantial
losses in excess of your capital.
Both instruments also enable you to
take a long or short position on a security.
There are costs and risks to either position
which you should be aware of and take into account in calculating your profit or
loss.
Extended settlement (ES) contracts
This is a forward contract traded on the
SGX to buy or sell a specific amount of
stock at a specified price, for settlement at
some future date when the contract matures. The contracts have a fixed expiry –
about 35 days from the listing date. You
do not need to hold the contract to expiry;
you can close out the position with an offsetting trade.
There are a number of advantages to
such a contract. With about 35 days to maturity, you are able to take a somewhat
longer view of the market. Since the price
at which you buy or sell is pre-determined, you can use the contract as a hedging tool.
Meanwhile, there are a few things to
bone up on in terms of how an ES works
and what triggers a margin call.
The mechanics
ES contracts are traded through a broker.
This will incur costs – typically, a broker-
How they compare
Product characteristics
Extended Settlement contract
Contract for Difference
Price
Forward pricing (can be higher or
lower than spot)
Price
Market or spot price
Leverage
Leveraged up to 20 times
Leverage
Leveraged up to10 times
Interest cost
No interest payment for tenure of contract
Interest cost
Always a finance charge (interest cost) to
the client (up to 8% pa)
Settlement
For long ES position, it will be settled into a
buy position. If not settled in 3 days, a force
sell will follow.
For a sell ES position, sellers’ free balance
share will be delivered. If no shares are
available, the normal buy-in process will
follow.
Low counterparty risk as clearing house
exists
Settlement
Cash settlement
Issuer risk
Source: SIAS
Leverage: a double-edged sword
Profitable vs loss-making leveraged trade
Investor who purchased 1,000 shares
of Company A with cash
Investor who purchased a product
with leverage (with exposure to
1,000 shares of Company A)
Quoted Price
$3
$3
Initial Outlay
$3,000 + Commission
$300 (assuming a 10% initial margin)
+ Commission
$0.5 x 1000 shares
= $500
$0.5 x 1000 shares
= $500*
16.67% (i.e. 500/3000 x 100)
166.7%* (i.e. 500/300 x 100)
Scenario A – Profit
Price rises to $3.50
Return on investment
(excluding commission and other
charges)
Scenario B – Loss
Price falls to $2.50
Return on investment
(excluding commission and other
charges)

 
*note that profit would be LOWER after
adjustment for finance charges
$0.5 x 1000 shares
= $500 loss
$0.5 x 1000 shares
= $500** loss
 loss of16.67% (i.e. 500/3000 x 100)
loss of166.7%** (i.e. 500/300 x 100)
 you will need to top-up the loss of

$200 (i.e. 500-300 initial outlay plus any
other margin calls
  
** note that loss would be HIGHER after
adjustment for finance charges
age fee, a clearing fee and GST on brokerage charges.
An ES contract, whether short or long,
will require you to put up an initial margin
or deposit. The size of the initial margin
may start at 5 or 10 per cent, but it will also vary depending on the volatility of the
underlying stock. As an example of a 10
per cent margin, for an ES contract to buy
or sell 1,000 shares of a stock priced at $1,
you will need to put up an initial margin
of $100.
You will also need to keep a maintenance margin, which is at least equal to
the initial margin. The broker may require
a higher maintenance margin, however.
The variation margin is the mark-tomarket gains or losses of your ES contract,
and is calculated daily. You must maintain a “required margin”, which is the sum
of the maintenance margin and variation
margin.
If the mark-to-market calculation at
the end of a trading day reflects a gain,
you can withdraw excess margins or use
that as collateral for new positions. If, however, there is a loss, you will be required to
top up additional margins.
A number of assets can be used as margin collateral, including cash, government
bonds, gold bars or selected stocks. You
will have to check with your broker on
what types of assets can be used as collat-
eral. Some brokers may charge an interest
if you use shares as collateral.
Eyes wide open
There are a number of significant risks to
take note of when you engage in this or
any form of leveraged margin trading.
45 Market risk. This is an obvious one,
which could give rise to other risks such as
illiquidity and margin calls. Basically you
will have to monitor market-related or
company-specific risks when you buy or
sell an ES contract. Ideally, you should be
familiar with the underlying stock, perhaps already hold it in your portfolio, and
also be acquainted with the industry it is
in. Other factors may affect its price, such
smart money 31
THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, JANUARY 22-23, 2011
as investor sentiment and liquidity. The
price of an ES contract may also diverge
from the price of the underlying share.
45 Margin calls. The amount of margin
required for a security is not static. In extreme conditions, a broker may raise margin requirements substantially. Worse
still, you could find that a security may
suddenly be deemed ineligible for margin
because of extreme volatility. This occurred in the midst of the 2008 financial
crisis. If this occurs, you could find yourself facing huge margin calls, and you may
have to top up the account by drawing
from your other assets.
SGX says in its investor guide to ES contracts: “If the investor fails to comply with
a request for additional funds within the
specified time, the broker may liquidate
the position and the investor will be liable
for any resulting deficit in his account.
The potential loss from trading ES contracts is therefore not limited to and can
be several times the initial margin paid
originally to support the position.’’
45 Liquidity risk. There is no assurance
of liquidity in ES contracts. An illiquid contract will increase the risk of loss as it
makes it more difficult for you to exit from
the position. A spike in investors’ risk aversion, a market crisis, or a company-specific event such as a trading suspension can
suddenly cause illiquidity.
You can track a contract’s liquidity by
looking at the volume of trading and the
open interest of the contract. The latter refers to the number of ES positions that remains to be liquidated by an offsetting
trade or satisfied by delivery. Some contracts are very thinly traded even in
non-crisis conditions.
ES contracts can be volatile, and this
may affect your daily mark-to-market positions.
45 Short positions and buy-ins. You will
also have to be careful on short positions
on ES contracts. In a short position, you
have to physically deliver the shares at expiry. It is, therefore, more prudent to enter
into a short position when you already
hold the underlying shares. If you do not
have the stock, on the settlement day the
CDP will buy-in shares on your behalf.
You will have to pay for the securities and
any other associated costs. A penalty
charge may also apply.
45 Safety of client margin accounts.
When you enter an ES contract, the settlement counterparty is the CDP. But your
broker’s inability to meet its obligations to
the CDP may have implications on your
account.
According to the SGX investor guide, if
a broker fails to meet its obligations to the
CDP due to a default by one of its customers, the CDP has the authority to use margins from the broker’s other non-defaulting customers placed with the CDP to
meet the firm’s outstanding obligations to
the CDP.
“A customer may hence not be able to
recover the full amount of funds in
his/her account if the broker becomes insolvent and has insufficient funds to cover
its obligations to all of its customers.”
If, however, a broker fails to meet its obligations to the CDP and the failure is not
the result of a default by one of its customers, then customer margins placed with
the CDP will not be used by CDP to meet
the broker’s outstanding obligations.
There are safeguards in place to see to
the segregation of client margin accounts.
Under the Securities and Futures Act, brokers are required to segregate client margins for ES trades from house monies. The
brokers will place the required amount of
customer margins and broker house margins with the CDP, which will maintain
the required segregation of accounts.
Brokers may not use the funds of one
customer to meet the margin requirements of another customer.
45 Corporate actions. ES contracts are adjusted to reflect the impact of corporate actions such as dividends, bonus shares,
stock splits and rights issues. SGX says
there are two main methods of adjustment. One is to the contract multiplier
which can increase or decrease depending on the corporate event. A second method is to adjust the settlement price in line
with the post-event price.
Contracts for Difference (CFDs)
CFDs are a form of leveraged trading that
is broadly similar to ES contracts, but they
also differ in significant ways. CFDs are actually an over-the-counter (OTC) derivative – you do not have to actually own or
take delivery of the underlying share as
trades are settled in cash. They are typically traded through a firm, known as a CFD
provider. You can also trade CFDs on a
range of underlying assets, including
stock, commodities and currencies.
Similar to ES contracts, CFDs are a way
for you to express a view on an underlying
asset – that is, you could speculate that
the asset will rise or fall. The transaction
will basically involve two trades: You open
the position with a trade through a CFD
provider and subsequently close it out
with a reverse trade. Unlike ES contracts,
there is no maturity date.
But similar to ES contracts, there is an
initial margin required – typically 10 per
cent. Your position will be marked to market on a continuous basis. If your position
falls below the margin required by the
CFD provider, you will have to top up to
cover the margins. If you are unable to top
it up, the position may be liquidated by
the provider without your consent or notice.
The risks of CFDs are also broadly similar to those of ES contracts. There is, for instance, market risk as CFD prices are subject to volatility and your view of the security could turn out to be wrong.
There is also the risk of a margin call. If
this occurs, you will have to top up your
account or be subject to a forced liquidation by the CFD provider.
There are some other risks worth noting:
45 Counterparty risk. Unlike ES contracts, which are traded on an exchange,
CFDs are entered into with a provider acting as principal. You will have to abide by
the terms and conditions set by the provider. The transaction can only be closed out
with the same provider. It is important
then that you ascertain the financial
strength of the provider and how well capitalised it is.
45 Pricing.
There are two approaches to
CFD pricing. One is that the CFD provider
could act as market maker to quote you a
bid/ask spread for the CFD. The price
quoted may not match the price of the underlying share or asset on an exchange.
A second approach is to use a “direct
market access” model, which is a more
transparent way to get prices, putting
trades through to an underlying exchange. This means the prices and volume shown an the provider’s CFD platform should be the same as the exchange.
With this, you may also be able to improve the spreads by posting your own
bid and offer prices into the exchange
cash market.
45 Costs. Commissions apply for CFD
transactions, and you will have to check
the rates with your CFD provider. There
are also financing charges, which may be
pegged to Sibor or an internal board rate.
When you hold a CFD position overnight,
interest is charged. When you hold a short
position overnight, interest is credited to
your account. There may also be a price
feed fee. Do check with your CFD provider on the fees applicable.
45 Corporate actions. These will be reflected in the value of the CFD account.
On dividends on a long position, for example, an amount equal to the gross dividend will be credited on the ex-dividend
date. The reverse happens on a short position, where an amount equal to the gross
dividend will be debited.
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Beware overtrading on leverage
TRADING on leverage may seem attractive because of the potential for outsized
gains, but it isn’t appropriate for everyone.
Traditionally, stock investors here
trade with leverage using a margin account which can be opened with any
stock brokerage. In the last few years,
more instruments have emerged that allow you leverage, and not necessarily incurring a financing charge.
Just as in a plain vanilla margin account, instruments such as contracts for
difference and extended settlement contracts add leverage to your trade as they require a fairly modest upfront capital. For
stocks, this initial margin or deposit is typically 10 per cent. This means you have to
put up $100 for trade whose total value is
$1,000. Your leverage factor is 10 times.
This makes for efficient use of capital.
If you were to buy the stock outright, you
would have had to commit $1,000.
Whether you trade CFDs or ES contracts, one obvious risk is that of adverse
price movement. You will be required to
maintain a minimum margin and your positions will be revalued daily. If the value
drops below the minimum required margin, you will face a margin call.
What type of investor may find leveraged trading suitable? If you are an experienced investor with a fairly high risk appetite, you spend time monitoring your positions, and you have the assets to back up
your trade, you may not think twice about
taking on leverage. Such instruments may
also be used to hedge the stocks or assets
in your portfolio.
You could, however, be burnt quite
badly if your view of the market turns out
to be wrong. Most investors’ undoing is
rooted in a propensity to overtrade, and
their reluctance to cut losses. The downside of a leveraged trade is potentially unlimited, particularly for those who do not
know when to call it quits.
It is prudent to take a leaf from the approach of some trading coaches. That is,
since leveraged trading is a form of speculation, set a limit on the amount that you
are willing to lose. That should normally
be a small fraction of your investible assets, perhaps just 5 per cent. And be disciplined enough to stick to that loss limit.
With CFDs, the trading platform that
you use typically allows you to set limits to
your position. Be aware, though, that the
loss limits may not be guaranteed. Some
CFD providers do offer a guaranteed stoploss facility, but they may charge a fee for
it. That fee is a relatively small proportion
of your transaction value, and may be well
worth the expense should the market gap
down suddenly.
Otherwise, if you have a non-guaranteed stop loss, there is no assurance that
the order will be transacted at the price
you have selected. In a market that is gapping sharply downwards, the order could
be executed at a much worse price than
you have specified.
GLOSSARY
Extended settlement contract: A contract between two parties to buy or sell a
specific quantity of a security, at a specific
price at a specified future date.
Contract for difference: A leveraged
trading instrument that allows you to speculate on the future market movement of
an underlying asset, without owning or
taking physical delivery of the asset.
Initial margin: The minimum margin
you are required to deposit to open a position in CFDs or ES contracts.
Maintenance margin: The margin that
must be maintained in your account for
outstanding positions in ES contracts.
Variation margin: Refers to the
mark-to-market gains or losses in relation
to the price at which the ES contract was
bought or sold. A net loss increases the required margin, and a net profit decreases
the required margin.
Margin call: A demand from your broker
or CFD provider to top up your account to
meet margin requirements. Failure to top
up could cause a forced liquidation of
your position.
By Genevieve Cua
This monthly column on financial
products is sponsored by
MoneySENSE, a national financial
education programme in
Singapore. Find out more about
other common financial products
at www.moneysense.gov.sg