Introduction of the derivatives market at the Nairobi Securities Exchange, dubbed “Next” two years ago, transformed the capital markets landscape in Kenya by offering investors an opportunity to diversify their investment portfolios. Next facilitates trading of futures contracts in the Kenyan market.
A derivatives contract is an agreement between two or more parties, usually a buyer and a seller, whose value is derived from that of an underlying asset such as a currency, stock or commodity.
When the value of the underlying asset changes, that of the derivatives contract takes a similar course.
Although the only products available are single stock futures and equity index futures, there is scope for introduction of more products with time.
Equity index futures are derivative instruments that give investors exposure to price movements on an underlying index, which in Kenya is the NSE 25-Share Index, while the equity single stock futures are based on price movement of several equities including Safaricom, KCB Group, Equity Group, Absa Bank, EABL and BAT.
There are two types of derivatives contracts. Those that are traded over the counter (OTC) and exchange-traded derivatives. OTC derivatives are often unregulated and are traded in private between banks, hedge funds, and other market players. Exchange-traded derivatives are highly regulated, standardised, and anyone can trade them on an exchange.
One simple way of trading derivative contracts is by using futures. Futures contracts are exchange-traded derivatives that give a trader the right and obligation to buy or sell an underlying asset at a specific price at a future specified date.
All futures contracts have an expiry date, upon which the underlying asset is delivered to the contract holder. Futures contracts are often leveraged, have low transaction fees and are settled in cash.
Another way of trading derivatives contracts is by using contracts for difference (CFDs). A CFD is a deal between two parties to exchange the value of a derivatives contract in cash between contract open and expiry. CFDs are very similar to futures except that it expires when a trader chooses to close the initial position.
To put it into perspective, a local online forex trading broker such as Scope Markets Kenya, may offer a trader the option to deal in Safaricom CFD shares. The Safaricom CFD contract will derive its value from the actual market value of physical Safaricom shares trading on the NSE.
If a trader buys one CFD share at a price of say Sh42 today, and then sells the contract a week later to the broker at a price of say Sh46, the broker pays the full amount Sh46 to the trader in cash. The trader benefits from the share price movement without actually owning the physical shares.
There are several benefits of trading CFD stock derivatives compared to trading physical shares. First, CFD stocks allow you to benefit when prices are going up and also when prices are falling.
Using a CFD contract, an investor can sell when they expect the price of a stock will drop. When it happens, the investor can buy back the contract at a lower price, thereby cashing the difference as the profit.
If an investor expects a company XY whose share price is Sh87 is going down, they can sell one CFD contract share at the current market price of Sh87. When the XY share price drops to say Sh57, the investor can buy back the CFD contract and make a profit of Sh30 for the trade, thereby benefitting when prices are going down.
The other advantage of trading CFD stocks is that your broker can offer you leverage. This allows you to trade a bigger position than your account balance. For instance, if a broker offers you a leverage of 1:5 on CFD stocks, you will be able to buy five shares at the price of 1.
This expands your opportunity when the price goes your way and expands your risk when price goes against your way.
Trading CFD stocks and stock futures allows a trader to access global markets on a single platform. This provides instantaneous order execution, higher market liquidity, and instant settlement of trades. There are costs associated with CFD and futures trading including fixed commissions per trade, and spread.
The tradeoff with physical shares is that you don’t pay CFD & futures holding fees on physical shares, but you equally pay commissions and spread.
The risks associated with trading CFD shares and stock futures include the same that are associated with trading physical shares.
However, in CFD shares and stock futures, the use of high leverage can significantly magnify your risk and reward per trade.
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