On 31 August 2009 trading starts for the fifth Make a Million competition. Last year, instead of buying actual shares for their competition portfolios, entrants had to buy single stock futures (SSFs) for the first time – a slightly more complicated and riskier game.

Buying an SSF does not mean buying the share; it means buying exposure to the share price movement. Because you don’t have to deposit the full value of the shares you’re interested in, a little money can go a long way – or really burn you if the price moves in the opposite direction than you thought it would!

How does an SSF work? You normally deposit about 15% (called margin deposit) of the amount that the shares would have cost you, but enjoy full exposure to the share movement. For example, if the shares are worth R10 000 when you buy your SSF contract and the share price subsequently increases by 10% (R1 000), your 15% (R1 500) margin deposit will yield a R1 000 profit – a return of 67%. But if the share price falls by 15%, for example, you lose your entire margin deposit – a negative return of 100%. If you need more examples, have look at my previous blog on how an SSF works.

How does buying SSFs differ from building a long-term, traditional share portfolio? With an SSF account:

• You could lose more than your capital when the share price falls quite sharply. (You may want to set up a stop-loss with your position to prevent this from happening.)
• You could leverage your profits, as you need to deposit only a fraction of the value of the underlying shares.
• You are usually less concerned with the business fundamentals of a company, as you could have lost either your margin deposit or your patience long before you see the true value of the company reflected in its share price. SSFs are more suitable to share traders than long-term investors.
• It’s easier to short a share. (Shorting is selling a share that you don’t own with the idea of buying it later at a lower price and making a profit.) If you believe that 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.

And how does playing the Make a Million competition differ from holding a normal SSF account with a broker? Well, in exchange for standing a chance to win that million, you need to put up with a few restrictions:

• You can only deposit R10 000 per competition entry, of which R9 000 is used as your margin deposit and the remaining R1 000 acts as an additional buffer which earns interest. Nothing stops you from opening several accounts, though.
• Unlike a normal SSF account, you cannot deposit extra funds into a Make a Million account. When you have lost your margin deposit due to the share price falling, you are out of the game.
• You cannot keep your position open after the last day of the competition. Before the close of trading on 13 November 2009, you need to have only cash and no more share exposure in your Make a Million account. With a normal SSF account you could continue your exposure for as long as you please and just roll the 3-month contract over from one quarter to the next.

SSFs are great instruments for those stock market players who want to gear up their capital seven-fold and don’t mind losing that capital when they make the wrong call.

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.