Investing with leverage

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#1
Business Times - 22 Jan 2011

SMART MONEY
Investing with leverage


A look at how two instruments - extended settlement contracts and contracts for difference - work. By Genevieve Cua

IF 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 brokerage 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-to- market 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 collateral. 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.


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 as investor sentiment and liquidity. The price of an ES contract may also diverge from the price of the underlying share.


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.'


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.


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.


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.


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:


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.


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.


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.


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.
gen@sph.com.sg

My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#2
Just a few questions I would like to ask everyone about leverage:

1. Does anyone here use leverage?

2. Do you think it is safe to use it?

3. Does anyone know how to do use it with minimal risk?

4. What is your preferred derivative (CFDs, Margin trading, etc.)?

5. If it is CFDs, what is the lowest margin required by a CFD provider in Singapore before they "margin call" you?
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#3
I don't use leverage and I don't think it is very safe. Perhaps I am either too conservative or just not well-informed enough. Rolleyes
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#4
Neither do I.

More Haste Less Speed.
欲速则不达。

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#5
Leverage is not necessarily totally bad.

Control leverage and not let leverage control oneself.

Never underestimate the power of leverage.

But, more prudently, never underestimate the destructive nature of leverage.

Leverage is a powerful beast that only few can tame. But, to the one that is sure of taming this beast, it can offer substantial rewards to it's master.

I will think of leverage as a lion which only an experienced trained lion trainer can tame and control it well to work for the master trainer.
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#6
(01-02-2011, 12:44 PM)jeremyow Wrote: Leverage is not necessarily totally bad.

Control leverage and not let leverage control oneself.

Never underestimate the power of leverage.

But, more prudently, never underestimate the destructive nature of leverage.

Leverage is a powerful beast that only few can tame. But, to the one that is sure of taming this beast, it can offer substantial rewards to it's master.

I will think of leverage as a lion which only an experienced trained lion trainer can tame and control it well to work for the master trainer.

Up this post. This is the most logical answer to using leverage. My test of the level of leverage one is comfortable with would be whether one is able to sleep at night while employing the beast.
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#7
(01-02-2011, 12:44 PM)jeremyow Wrote: Leverage is not necessarily totally bad.

Control leverage and not let leverage control oneself.

Never underestimate the power of leverage.

But, more prudently, never underestimate the destructive nature of leverage.

Leverage is a powerful beast that only few can tame. But, to the one that is sure of taming this beast, it can offer substantial rewards to it's master.

I will think of leverage as a lion which only an experienced trained lion trainer can tame and control it well to work for the master trainer.

May I provide a different opinion to kazukirai-san.

The above sounds good, is actually very true in its contextual POV.
However, in the sentence of "only few can tame", many newbies looking for a quick buck, esp. those under-capitalised, would be thinking "why not ME?"

There you have it, everyone thinking himself as a Superman in a bull run, with the increasing share/options prices providing a destructive reinforcing confidence to the trader that he, as a newbie can do leverage well.

Only when the tides are turned that he find himself very naked, and more so since he is being leveraged THE OTHER WAY by the market forces this time round.

So dun leverage unless one is well capitalised, or one is trying to explore an aternative investment universe, options/forex. Do it with your toes into the water and do it for one full market cycle first.

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#8
(01-02-2011, 09:35 PM)arthur Wrote: May I provide a different opinion to kazukirai-san.

The above sounds good, is actually very true in its contextual POV.
However, in the sentence of "only few can tame", many newbies looking for a quick buck, esp. those under-capitalised, would be thinking "why not ME?"

There you have it, everyone thinking himself as a Superman in a bull run, with the increasing share/options prices providing a destructive reinforcing confidence to the trader that he, as a newbie can do leverage well.

Only when the tides are turned that he find himself very naked, and more so since he is being leveraged THE OTHER WAY by the market forces this time round.

So dun leverage unless one is well capitalised, or one is trying to explore an aternative investment universe, options/forex. Do it with your toes into the water and do it for one full market cycle first.

Hi Arthur-san,

I don't think we're on a different page at all. I'm not advocating the use of leverage nor promoting it. While you may be leaning towards a more cautionary note, I quoted jeremy-san's entire post precisely because it is mentioned that Leverage is a beast.

I'm advocating critical thinking hence my line on the optimal use of leverage as a level that one is comfortable with. Personally, I hardly use any (well, except for my car loan at present).

I believe thinking critically is one of the most important skills to develop. If there are any younger 'investors' who think that they are Superman and end up going to lose it all due to taking on excessive leverage while the tide goes out, I think it may not necessarily be a bad thing as the lessons learnt would have come at a time where they are young enough to make mistakes. And relative to being at the conventional retirement age and losing the entire nest egg...I think that is a better option.

However, kudos to you for spelling it out as a cautionary note. I believe that is a public service annoucement all newer investors should heed.
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#9
Just sharing my personal experience on using leverage:

http://singaporemanofleisure.blogspot.co...r-bad.html

At the end of the day, we have to walk our own paths. Different strokes for different folks!
Just google singapore man of leisure
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