Education

What are Derivatives Market?

Derivatives are instruments whose value depends on some other more basic underlying asset or commodity. It includes a broad class of instruments that include Forwards, Futures, Options and Swaps. Derivatives markets enable corporations and individuals to manage and reduce risk and control exposure to adverse price movements associated with holding an underlying asset or commodity. Derivatives markets also provide tremendous opportunities for investors to profit from the price movements in the underlying markets.

What is Futures Contract?

A Futures Contract is a legally binding agreement made between two parties to buy or sell a commodity or financial instrument, at an agreed price, on a specified date in the future. The quality and quantity of each contract is standardised, hence, the price at which the contract is established is the only variable and is determined between the buyer and seller at the time when the contract is traded. Futures Contracts are listed on Exchanges and the performance and obligations under the contract are guaranteed by the Exchange's Clearing House.

Why Trade Futures?

Futures offer unique profit opportunities in bull or bear markets since players can initiate buy or sell positions. Investors can profit from any price volatility as a result of global developments that will impact the financial and commodity markets. Futures also allow investors to take advantage of leverage factor by holding a larger investment value with a smaller capital outlay and returns greater than the same value equity investment. Futures also provides a mechanism for hedging adverse price movements associated with holding an underlying portfolio of equities, financial instrument or commodity.

Who are the Players?

Institutional Players - as fund managers, insurance companies, financial institutional, commodity trading house and refineries are among the most active players in the market. Futures contract allow them in managing their portfolios and diversification of risks. Hedgers - market participants who use their strategies in derivatives market to minimize their risk exposure in the underlying market. Local Participations and Retail Investors - individual investors or traders who assume risk in return for trading profits.

What are Stock Index Futures?

Stock Index futures are derivatives instrument whose value depends on the value of the Underlying Stock Market Index. The underlying index for the FKLI is the FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI) which is a market capitalization-weighted index of top 30 blue-chip stocks of Bursa Malaysia.

What are Commodity Futures?

Commodity Futures are derivatives instrument whose value depends on the value of the Underlying commodity. Crude Palm Oil Futures (FCPO) is derived from the underlying physical Crude Palm Oil prices where a contract is made between a buyer and seller to take and make delivery respectively of CPO at a future date. It is a physical-settled contract, upon expiry of the contract, the buyer has to take delivery of the physical CPO. FCPO prices are determined by market supply and demand with Bursa Malaysia Derivatives Berhad providing the marketplace for players to trade.

Types of Orders

  • Market orders - These are orders placed for immediate execution at the best available ask or bid price in the market. Generally, market orders are used when the trader wants a trade-done quickly and is not too concern with negotiating for a better price.

  • Limit orders - A limit order stipulates a price limit for the execution of the transaction. A buy limit order indicates that the futures contract may be purchased only at the price designated or at a lower price. A sell limit order indicates that the futures contract may be sold at the price designated or at a higher price.

  • Stop order - A stop order may be used to stop loss, to protect profit or to initiate strategies based on stipulated price levels. Whenever the futures trades at or beyond the designated price of a stop order, the stop orders convert into a market order in the electronic trading system. This conversion is done automatically. A buy-stop order specifies that the order is not to be executed until the market rises to a designated price. A sell-stop order specifies that the order is not to be executed until the market price falls to a designated price.

  • Stop Limit Order - It is a buy or sell order that is to be executed at a specified price or better, once the price of the instrument in the market has reached the trigger price that has been specified. Stop limit is best used when an investor wants to enter or exit market at certain specified prices know as Trigger and Limit prices.

  • Day Order or Good for the Day - The limit or stop order will lapse at the end of the trading day if no particular date has been set for its validity.

  • One Cancels Other/Order Cancels Order - A two-leg order (stop vs limit) where the profit target is set with a limit order, while a stop order provides protection from losses.

  • Good-To-Date (GTD) - This order remains valid until the end of a specified trading date

  • Good-Till-Cancel-Order (GTC) - This order remains valid until either filled or cancelled, or until the contract month expires. It is prudent that a record of such orders is kept and monitored on a daily basis.

  • One Cancels Other / Order Cancels Order - A two-leg order (stop vs limit) where the profit target is set with a limit order, while a stop order provides protection from losses.

  • Basis Orders - Also known as spread orders, basis orders are used for taking a spread position, i.e. the simultaneous purchase and sale of contracts with different expiration date. The trader attempts to make a profit from changes in the differential between the market price of the respective contract months as time goes by.

Initial Margin Deposit

Futures contracts provides leverage through margin where an investor needs only put up a marginal sum of the contract value instead of the full amount of the contract value. This sum of money is often referred to as the Initial Margin.

It is a form of good faith deposit which ensures that counter-parties to the transaction can pay the cash difference when the trade is settled. Margins are required to be deposited with the Futures broker to start trading.

A case study on FKLI product margin calculation. Assumptions made on the current margin requirements for FKLI futures contract is:

  • Initial Margin (Outright Position) RM2,500
  • Brokerage is not calculated for the sake of simplicity in calculation
  • Investor would like to long/buy a Futures contract and he has to bank-in initial margin of RM2,500 for a lot of FKLI contract.
  • Trading Day One (T Day)
    Investor A initiated a long position for FKLI spot month at the price of 1270.0. Assuming that end of the day the settlement price is at 1270. Thus, he is not making any profit and loss and equity remain at RM2, 500.
  • Trading Day Two (T+1 Day)
    Strong buying moved index futures contract higher by 10 points at the close of trading day two. Because his position is marked to market, Investor A receives RM500 in his margin account as the variation margin.. Thus his equity as of closing is RM3,000.
  • Trading Day Three (T+2 Day)
    Market condition was not favorable on trading day three and index futures contract fell 15 points to 1265. Investor A's margin account will be debited by a variation margin of RM750, leaving his equity balance at RM2,250.There is a margin call of RM250, as the initial margin required is RM2,500. Thus he has to bank-in RM250 to top up the margin on next day.
  • Trading Day Four (T+3 Day)
    After top up of RM250, Investor A equity balance is at RM2,500. With the bullish factor, Investor A took profit by selling at 1290. Having closed-out the position, Investor A margin account is added RM1,000 and net equity balance now is RM3,500

This table below illustrated the day-today account balance for Investor A

Trading Day Futures Index Level Profit / Loss (RM) Equity Balance (RM)
11270.0-2,500
21280.0500 (10x50)3,000
31265.0750 (15x50)2,250 (Top up 250 to 2500)
41290.01,000 (20x50)3,500

Glossary
This glossary was compiled by HLIB from a number of sources. The purpose of this compilation is to promote a better understanding of the futures market. The definitions are not intended to state or suggest the correct legal significance of any word or phrase.
AskThe price that the market participants are willing to sell.
BidThe price that the market participants are willing to pay.
Bear MarketA market in which prices are declining.
Bull Market A market in which prices are rising.
Cash Price Market price of the underlying contract. Also called spot price.
Final Settlement Final disposition of open positions on the last trading day of a contract month. Occurs in markets where there is no actual delivery.
Contract MonthA specific month in which delivery or cash settlement may take place under the terms of a futures contract. Also called delivery month.
ConvergenceA term referring to cash and futures prices merging as the futures contract nears expiration, that is, the basis approaches zero.
Hedge The purchase or sale of a futures contract as a temporary substitute for a cash market transaction to be made at a later date. It involves having opposite positions in the cash market and futures market at the same time.
HedgerA person or firm who uses the futures market to hedge.
LeverageThe use of a small amount of assets to control a greater amount of assets.
MarginFunds or collaterals that must be deposited by a customer with his broker, by a broker with a clearing member or by a clearing member with the clearing house. The margin helps to ensure the financial integrity of brokers, clearing members and the exchange as a whole.
Margin Call A call from a clearing house to a clearing member, or from a brokerage firm to a customer, to bring margin deposits up to a required minimum level.
Mark-to-Market The daily adjustment of margin accounts to reflect profits and losses.
Open Interest Total number of futures contracts that have not yet been offset or fulfilled for delivery.
PremiumThe excess of one futures contract price over the cash market price.
VariationMargin Futures positions are revalued daily at the closing price, and variation margin is the payment (receipt) of losses (profits) reflected in the customer's account based on the daily revaluation.

The trading phases and market timing for the different products are set out below.

Market Timing for FKLI / FCPO

Trading PhasesIndex futures (FKLI)Commodity futures (FCPO)
Pre Opening8.15 am10.00 am
Continuous Trading8.45 am10.30 am
Close12.45 pm12.30 pm
LunchLunch Lunch
Pre Opening2.00 pm2.30 pm
Continuous Trading2.30 pm3.00 pm
Close5.15 pm6.00 pm


FKLI, FCPO
Research Centre
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