Before you plunge into Extended Settlement (ES) contracts, be warned that the product is not for every retail investor. Financial experts caution that it is more suited for short-term traders with higher risk appetites, and for sophisticated traders.
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Pros and cons of extended settlement trading
Before you plunge into Extended Settlement (ES) contracts, be warned that the product is not for every retail investor. Financial experts caution that it is more suited for short-term traders with higher risk appetites, and for sophisticated traders.
The ES contract is a useful tool for investors who understand and employ hedging and arbitrage strategies to improve their trading positions.
Arbitrage is taking advantage of price differences on two different markets, for example. Still, the product is not without risks.
Here are some of the pros and cons of ES contracts.
Pros
Said Mr. Michael Wong, Phillip Securities’ director of business development: ‘In the past, retail investors either had to stay out of the bear market totally or simply do nothing and watch their portfolio decrease in value. Now, they can protect their portfolio through hedging using ES contracts or participate in the bear market by short selling the shares.’
He added that another advantage of ES contracts is the opportunity to arbitrage between the ready market and the ES market, since ES prices converge on the last trading day when ES contracts are physically settled into the underlying.
Mr. Gabriel Yap, senior dealing director at DMG & Partners Securities, said that investors need only fork out a small outlay which is the margin deposit before trading an ES contract.
Cons
The small initial outlay required may work against the investor, who might be tempted to over-extend himself by buying too many ES contracts with the sum he has to invest, said Mr. Andrew Ler, SGX senior vice-president & head of private investors.
For example, while an investor may be able to buy only one lot of a company’s shares for $5,000, he may be able to buy 10 lots of ES contracts for the same $5,000 if the margin of those contracts is 10 per cent. He should bear in mind that when the ES contracts are due for settlement, he would have to pay the balance of $45,000.
A major risk is volatile price movements, which can result in substantial losses when the share price moves against the investor.
As investors place only a small margin to trade ES contracts, they may be called upon to top up these margins if the price of the underlying security should vary too much from the price of the transacted ES contract.
For instance, let’s assume an investor buys a March ES contract on Company X for $10. If the margin of the contract is 10 per cent, he pays $1,000 as the initial margin. This is calculated from $10 x 1,000 shares x 10 per cent.
When the price of the ES contract drops to $9.50, his margin requirement similarly drops to $950. This is worked out from $9.50 x 1,000 shares x 10 per cent. But as he has now incurred a paper loss of $500 - as calculated from ($10 - $9.50) x 1,000 shares - he has to top up his margin. His required margin is now $950, plus the paper loss of $500, which amounts to a total of $1,450. As he earlier paid $1,000, he now has to top up his margin by $450.
The serious potential consequences are that investors of ES contracts could lose far more than they stumped up initially, and any top-up on the margin, if they overtrade, said Mr. Wong.
While investors can short-sell ES contracts, they must ensure that they either cover their outstanding positions by buying back the same ES contracts or the actual shares by the settlement date. If this is not done, the SGX would force-buy the required shares to cover the investor’s outstanding positions and the investor faces penalties for failing to deliver on the settlement date, said Mr. Ler and Mr. Wong.
Lorna Tan
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