Investing in the Futures Market - A private guide for Clients

Introduction

The derivatives markets serve an important purpose in modern economies particularly in the transfer of risk from those wishing to avoid risk, to those prepared to take risk (in the hope of a substantial return).
Whilst the markets are primarily used by professional investment managers, they often have a great appeal to the part-time investor. Such parties must however, ensure that they enter the markets with their eyes open, as the rewards can be high, but the downside can be equally enormous.

Should I get involved?

Before getting involved in derivatives, a potential participant must examine their motives for using the products offered. Generally speaking there are four broad categories of market participant.

those who use futures and options to protect an existing portfolio ( or anticipated investment) against possible adverse market movement,

ARBITRAGEURS:

those who profit from price differentials of similar products in different markets, e.g. price differentials between the spot and futures price of a commodity. Usually only the professionals get involved in this area,

INVESTORS:

those who use futures to enhance the long-term performance of a portfolio of assets

SPECULATORS:

those who use futures for short-term profits, e.g. to "bet" on short-term moves in the market.

Clearly futures are very useful tools for those in categories 1 to 3 . They can also be excellent tools for speculators, but the pitfalls are great and the inexperienced must beware.

Should I be speculating?

On the face of it, the chances of making a profit or loss speculating in futures appear to be equal. In reality, the picture is much more daunting: studies of non-professional speculators trading in futures in the USA show that over 90% lose money.

Furthermore, speculating in futures can be more dangerous than speculating in any shares, because of the gearing effect. With shares the most you can lose is what you pay initially, whereas with futures you can lose multiples of your original outlay.

To make matters more difficult, profits and losses are calculated on a daily basis. So even if your position does well over a period of 3months, this could be to no avail if the market moves adversely at any time during the life of the contract.

For example, a percentage move in the All-share index of the same magnitude as during the October 1987 crash, could see you lose 3 times your investment in the All Share index future - in only 3 days. Being on the right side of such a move would obviously be extremely profitable for a speculator, but the downside potential must be realistically assessed.

While professionals are generally in a better position to be speculating than the man-in-the-street, they are certainly not immune to huge losses. The collapse of Barings Bank, for instance was caused by speculation in futures.

So be sure you know what you are getting into before you get involved.

Choosing a Broker

The SAFEX membership is made up of banks, JSE brokers, independent brokers, institutions and corporates. Commissions are negotiable and members may trade either as principles (i.e. from their own books) or as agents (on behalf of clients).

You can get an updated list of members from the SAFEX membership secretary or from the Members link on this site. This list also shows whether the member is a broker or not. Try to find out a little about the broker you are considering using. For instance, look at:
The financial security of the member;

• If the broker offers you huge returns, why is he bothering to do so with your money and not his own?
• How will you be charged? If the broker is paid according to the number of trades he performs, he may be tempted to overtrade. (This is called "churning" and his highly unethical)
• Does the broker guarantee a stop-loss (in-writing)on your account? If the market moves strongly against you, will the broker look after your interests before those of his bigger clients?

The are undoubtedly clients who have had good experience with managed funds, and there are also many brokers who manage funds honestly and ethically. Nevertheless, you should be extremely cautious before giving someone else discretion to trade on your behalf.

Most importantly, insist on daily statements and, if the promised profits do not materialize in good time, cut your losses and get out!

The Client Agreement

SAFEX lays down the minimum conditions for agreements between clients and members in the Client documentation pack. Therefore, the agreements you sign should be very similar, irrespective of the broker you have selected.

Even though you may be keen to start trading very rapidly, due time and care should be given to a comprehensive study of the agreement. The agreement describes the relationship with your member, explains your sights and obligations and those of your broker and should include things such as fees to be paid.

Cash management

Your broker will require you to deposit an amount of money with him, in order for you to start trading. In order to make life easy both for you and your broker, a few pointers should be followed:
Avoid leaving large amounts with your broker: settle your account regularly;

• Make sure the cash is in a trust account;
• Check beforehand what interest rate you will earn on your account;
• Avoid borrowing money from your broker. This only increases gearing, and hence risk;
• Never forget that it's your money and can be withdrawn at any time.

Responsibilities of the Exchange

Whether you are an existing client or a potential client, the staff at the JSE are available to assist you with your problems or queries. In pursuit of the JSE's constitutional objectives, to establish, operate and regulate a financial market where trading will be conducted in a fair and orderly manner, the infrastructure under which the market operates is designed to ensure fair treatment for all participants. If, as a client, you are unsure of any issues relative to your involvement in the market, we suggest that you contact the JSE. If you feel your broker has not given you a fair deal, the JSE Surveillance Department will investigate any complaints you have.

Up to date information, including statistics and prices, are available on this site.