Gain leverage

Leverage refers to the ability to gain greatly magnified profits through a relatively small initial investment. Through the use of futures and options, small price movements in the underlying share, index, commodity or other asset can provide investors with substantial potential returns or losses. This is because futures and options allow investors to purchase a large amount of exposure to price movements in the underlying asset for relatively little cost. Profits can be magnified by many times, just as losses can be.

Futures example:
The FoX15 futures contract is valued at the current NZSX 15 Index level multiplied by $10. So, if the NZSX 15 Index is at 5050, by buying a FoX15 futures contract you are controlling the same risk as buying a portfolio of $50,500 of shares representative of the top 15 companies' securities included in the NZSX 15 Index. However, you only need to lodge an initial margin of $770 to buy or sell the FoX15 futures contract. If the FoX15 futures contract moves in your favour by 20 points then the return is $200 on your investment of $770, or 26%.

Options example:
Imagine Telecom's share price is $5.80. You could spend $5800 to buy 1000 Telecom shares. If Telecom's share price is $6.50 in three months' time you make a 70c profit per share by selling the shares (a return of 12%). However, if you bought a $6.00 Telecom call option (giving you the right to buy 1000 Telecom shares at $6.00) for a premium of say 20c per share (or $200 for one option) and the share price goes to $6.50 in three months' time, you make $300 (a return of 150%) because you have the right to buy the shares at $6.00 and can sell them instantly at $6.50 which is a profit of $500 minus the premium of $200.

Profit from a rising or a falling market

Unlike equity investing, where profits come from rising share prices only, futures and options give you the opportunity to profit from rising as well as falling prices. To profit from a falling market you can sell futures then buy them back at a lower price.

Rising market example:
You believe the NZSX 15 Index will continue to rise through the day. To take advantage of this opinion, you buy one FoX15 futures contract. The underlying NZSX 15 Index is at 5035 and the FoX15 futures contract is trading at 5050. The contract value is $50,500 (5050 x $10). The market continues to rise and you decide to close-out your position by selling a FoX15 futures contract when the contract reaches 5080. The contract value is now $50,800 (5080 x $10). The difference between the buy price (5050) and the sell price (5080) is 30 points. Your profit is 30 points x $10 = $300.

Falling market example:
You believe the NZSX 15 Index will fall due to a decline in overseas markets. To take advantage of this view, you sell one FoX15 futures contract today. The underlying NZSX 15 is at 5035 and the FoX15 futures contract is trading at 5050. The contract value is now $50,500 (5050 x $10). The market does fall and you decide to close-out your position by buying one FoX15 futures contract for the lower price of 5015. The contract value is $50,150 (5015 x $10). The difference between the sell price (5050) and the lower buy price (5015) is 35 points. Your profit is 35 points x $10 = $350.

Develop a range of investment strategies

By combining different futures and options products in your investment plan, you can use trends and variations in the marketplace to your advantage in ways that are not possible with traditional investment products. You have the opportunity to create a range of profitable scenarios regardless of the direction of the market.

Hedging

You can protect the value of your portfolio by entering into futures or options contracts that have characteristics similar to your portfolio. Using the futures and options market to take an equal and opposite position to the exposure to price you have in your portfolio can be an effective hedging tool against adverse price risk.

Example:
You have a diversified portfolio of $150,000 in New Zealand shares and you believe the NZSX 15 Index may decline the alternatives are to:

• sell all or part of your portfolio
• sell futures contracts to hedge against the risk of prices falling.

By selling futures you are protecting against a fall in the market in the same way as many New Zealand companies use forward foreign exchange to cover adverse moves in the foreign exchange rate when importing or exporting.

If you sold three futures contracts and the market fell 10% the portfolio would be worth $135,000 but the futures would show a profit of $15,000 to offset the lower value of your portfolio.