On 3 November, when trading starts for the 2008 Make a Million competition, thousands of South Africans will experience first-hand how derivatives work. Unlike previous years, when entrants bought the actual share, they will now be buying single stock futures (SSFs) – a leveraged and slightly riskier game.

What is an SSF?

An SSF is a 3-month futures contract, of which the price is linked to the actual listed stock (aka share). When you enter the contract as a long position, you are betting that the share price will rise during the contract term; when you enter as a short, you are betting that the share price will fall. At the moment there are more than 250 SSFs available on the South African Futures Exchange.

How does it work? An example:

Say you want to buy 100 Anglo American ordinary shares, but don’t have the capital required. With SSFs you can get exposure to the share price movement over the next three months, but with less capital. This is how it works.

The pricing: If the Anglo American ordinary share (AGL) price was R300 today, you could expect the December 2008 futures contract to be priced around R31 000. That is because you have to buy SSFs in lots of a 100 each (R30 000 for a 100 of AGL) and the financing cost or interest is then added to this amount. If dividends are expected before the futures contract close-out date, the dividend amount is deducted to reach the AGL SSF price.

The margin deposit: You don’t have to provide R31 000 to buy the AGL SSF contract, though. You only put down the required margin, which depends on the volatility of the underlying share price and can be anything between 10% and 20%. Let’s say the margin for the AGL SSF at the start of the futures contract is R4 600. That’s all you need to give your broker when you buy the contract, which is exactly why you are paying a financing cost on the value of the underlying share. This is a geared investment (i.e. with borrowed money). Just keep in mind that, as far as price movements are concerned, you are exposed to a R30 000 asset. If it loses R3000 of its value, you carry the full R3 000 loss.

The contract period: There are four SSF contracts per year for each share. Your December AGL SSF contract will expire on the third Thursday of December, i.e. 18 December 2008. If you don’t sell your contract earlier, you will end up with any increase in the AGL share price (x100) in your cash account on that date.

Margin top-ups: In the mean time, until you sell the contract or it automatically expires, it could get tricky if the share price falls. Say the AGL price drops from R300 to R270 in one day. With your contract of 100 shares, this means you end the day with an unrealised loss of R3 000. The broker will automatically take R3 000 from your cash account to recover the loss. If you don’t have enough money in your cash account, you’ll have to deposit extra money with your broker.

How does buying SSFs differ from buying shares?

• You get more gearing. If you want to borrow money to buy a share, you usually have to provide at least 70% of the capital and a bank may lend you the other 30%; with a SSF you get exposure to the total movement in the share price with only a 10 to 20% margin deposit.
• You could lose more than your capital. If your margin deposit was only 10% and the share price falls by more than that before you get a chance to sell out of your position, you’ll have to pay in more money.
• It’s easier to short a share with an SSF. If you believe the share price is going to fall, you can just instruct your broker that the SSF contract is a short position.
• You generally pay lower brokerage on SSF transactions.
• Buying SSFs is not a buy-and-hold game. You need to watch the share price daily and decide whether it may be necessary to close out your position. Unlike shares, you can’t just sit out a large price decline until it recovers a few months or years later. With price volatility, your cash account could increase or decrease dramatically from day to day – or even turn negative.
• While you can either invest in shares or speculate on their short-term price movements, the 3-month contract term of an SSF is too short for fundamental investment principles. Unless it’s being used to hedge out short-term share price volatility, SSFs are traders’ instruments.

The Make a Million competition

For competition entrants a few additional restrictions apply, e.g. the compulsory closing out of positions when you’ve lost more than half of your margin deposit. Visit www.makeamillion.co.za for more details.