Not everyone is into stocks.
There are many people that don’t invest in a specific manner. They certainly do not have time to buy and hold stocks, or the temperament to analyse listed businesses deeply and make purchase and sale decisions on fundamentals.
The majority of peers and acquaintances are not familiar with specific stocks.
However, everyone is familiar with the main blue chip stock index of their country. If you are a Singaporean, you will be familiar with the Straits Times Index, if you are a USA guy, you will be familiar with the Dow Jones Index or the S&P 500 Index.
When the prices goes up and down, they do not know it daily, but they have one eye on the general direction.
It is no surprise that people who have the speculative streak wishes to be able to speculate on the direction on the index.
Thus at one time, structure warrants, issued by financial institutions, which allows a speculator to make leveraged gains on the index, or particular stocks, were popular.
They are not so these few years, however warrants’ volumes are growing again (up 400% in 1 year), demonstrating the retail interest in leveraged products. The same applies to CFDs or for example CBBCs in Hong Kong.
Some of the gripes is that warrants, which are an option derivative variant, are more complex. Even if you get the direction of the index correct, various factors might mean you are not making money, or subject to losses even.
Thus, SGX decided to work with Societe Generale to bring to this region a product that is the most popular leveraged product in Europe nowadays.
Singapore is the first country in Asia where these products are tradable.
This financial instrument is called Daily Leveraged Certificates (DLC in short), which are targeted at sophisticated investors and is tradable on SGX since 17 July.
Let me sought to go through some of its characteristics and who it is suitable for.
What Daily Leverage Certificates (DLC) are
My first impression of DLC is that DLC sought to be a less complex way of speculating in news flow that a speculator can attempt to profit from his interpretation of how events will affect markets.
DLC provides you the ability to Long or Short Indices
Indices are a basket of stocks or securities formed by some financial institutions, to act as a representation of the performance of a particular sector, geographical region or country.
The Hang Seng Index(HSI) for example, tracks the performance of some of the largest companies in Hong Kong. Currently it is made up of 50 stocks. Hang Seng Indexes Company Limited, which is a subsidiary of Hang Seng Bank, calculates the index.
DLC is a structured product. It is an instrument whose value is based on another asset. In this case a DLC on the HSI is a structured product whose price movement changes when the HSI value changes.
When you buy a Long DLC, you are speculating that the direction of the value of underlying asset e.g. HSI will go up. Your DLC value goes up. Then you sell off your DLC for a profit.
When you buy a Short DLC, you are speculating that the direction of the value of underlying asset HSI will go down. Your DLC value thus goes up when the HSI value goes down. Then you sell off your DLC at a higher price, to earn a profit.
Thus, with the DLC, the speculator is able to make a play on how the indexes will change due to changes in events.
For the start the designated market maker Societe Generale will launch DLC products linked to 4 indices:
Leveraged is built into the DLC and fixed at 3 Times or 5 Times
DLC is leveraged comparable to a CFD which has changing margins payable on a daily basis.
A DLC does not have margins, but the payoff is comparable.
On a daily basis, the price change of a very broad market index is quite low. Typically, the price movement is less than 1%.
It is only when volatility picks up you get greater than 2% movement.
As a speculator, to profit from this, you have to increase the size of your capital, so that it is meaningful. One way is to make use of CFD because you can leverage upon them, putting only a small amount of your capital and borrowing the rest of the capital. Else it is through warrants, which have leverage built in.
With DLC, the leverage complexity gets is solved for you by the issuer. There are 2 levels of leverage 3 times the price movement, or 5 times the price movement.
In this way, you can speculate without a large amount of capital.
When you buy a $2 DLC, it actually means your market exposure (based used ofr your returns) is $10. If you invest $1000, it actually means that you are buying $5000 in the underlying index.
A 1% move of this $5000 (equals $50) thus results in the value of your DLC investment growing to $1050 or +5%.
The Returns of DLC are Less Complex
The returns are simpler because there are fewer nuances to think about. Recall that warrants used to be one of the main speculative tools but in recent times we have heard of less conversations about it.
Warrants are European style options. With options, part of its value is time dependent. Suppose a warrant is issued at $0.40. If you do not exercise this option and let it expire, the value of the warrant goes down to zero.
Another permutation that affects the price of warrants is that the value change of the warrant is determined by the change in volatility, rather than the price. This can be confusing for some speculators when they see the price of HSI move in the direction they wanted but the price of the warrants does not change.
The time and volatility element is taken out of the DLC. A DLC simply gives the investor 3 or 5 times the move of the underlying. When HSI is up 1%, the 5x DLC will be up 5% on the same day.
In a way, the return you will get will be the change in daily price of the underlying x the amount of leverage – the cost and fees.
Suppose the HSI changes in 1 day from 24,000 to 24,480. This is a 2% change in value. The HSI 5X Long DLC will move up 5 times faster or 10% before cost. The HSI 5X Short DLC will see a loss of 5 times of this daily move or a -10% return before cost.
DLC Compounding Effect Means it is meant for Short Term Intraday Trading
For those who are interested in using DLC to speculate over the short term, but your short term is 1 month, I urge you to think again.
Let me try to explain it here.
The leverage of the DLC is based on the price change from the day before.
This means that suppose:
- The underlying asset changes 0.38% in value today. The DLC’s return will be impacted by leverage so if it is a 3X leverage, then the intraday return of a Long DLC is -(-0.38) x 3 = 1.14%.
- The next day, the underlying asset changes in value by 1%. The same DLC will rise in value by -(1.00) x 3 = -3%.
- Over 2 days, the DLC has moved up 1.14% and 3% which results in a 2 day total return of 4.44% while the underlying index moved up a total of 1.47% over two days. The Long DLC’s return is thus slightly higher than 3 times 1.47% or 4.41%, which is due to the compounding effect.
The performance each day is locked in, and any subsequent returns are based on what was achieved the day before. This process is known as compounding.
The significance of this compounding to you is this:
- If the underlying HSI index is trending, you get compounded returns (more than 3x or 5x the move)
- If the underlying HSI index is not trending, but going up and down and up and down, your returns will look vastly different and most likely will be smaller over multiple days.
The illustration above shows the same DLC’s returns based on 2 different volatility profile on the same index.
Folks who read my sequence of returns risk article for financial independence or retirement will be familiar with this concept.
Over a 3 day period, the underlying index, say HSI has the same return: +4.05%. The difference is the individual day change. The trending market (left) has 3 positive days while the volatile market(right) has 2 positive days sandwich by a negative day, which price movement is larger.
The return on the same DLC is different, with one being 21.3% the other being 15.50%.
This means that if you wish to speculate over a 2 week duration, and this period is volatile, even if you get the direction right, your return profile might be drastically different.
Therefore this product is meant for short term speculation.
Less Hurdle to be Profitable after Cost
If you are speculating in stocks or warrants, the commission can be quite hefty for traditional brokers.
If your trading size (no of shares) is small, you have to find cash upfront accounts that give you commission rate that are half the traditional commission.
Before any price movement, you are -0.20% or -20 basis points in the red and would have to earn greater than this amount to break even.
Some assumptions below is how a typical retail client using one of Singapore’s brokerages will incur:
- Retail Trading Commission: 20 bps
- SGX trading and clearing fee: 0.5 bps
- Total round-trip fee: 41 bps
- Trade with three tick profit (e.g. SGD 2.10 to SGD 2.13) results in a 143 bps profit
- Net of fees this would comprise a 102 bps gain (~1%)
A single tick movement for a typical DLC will be
- 0.001-0.199 : 0.001
- 0.20-1.95: 0.005
- 2.00 and above: 0.01
A single tick movement, the profit if it moves in your direction is 0.40% – 0.50% or 40 basis points to 50 basis points.
Based on the round trip commission of 41 basis points, the hurdle to break even is much less.
If the DLC moves more than 1 tick your trade becomes profitable. According to the first week of trading, statistics published by SGX, the DLCs move on average from 6 to 20 ticks a day naturally pending the activity in the market and the DLC leverage level (higher = more ticks movement).
There is a Time Expiry to Each DLC
Each DLC have a finite lifespan and will cease to exist on expiry date. The maximum is 3 years.
The difference is that time decay do not affect the value of the DLC.
Mitigating the Rate of Loss
DLCs have built in 3x and 5x leverage.
So this means that if the intraday price change is 33% or 20% in the main index, the DLC will approach 0 (an index move of -20% times 5 would imply your investment is gone).
An airbag mechanism is built into the DLC to slow the rate of loss in the value of the DLC in extreme market conditions.
The Air Bag effect comes into play during a pre-determined movement in the underlying index. The trigger of this Air Bag depends on leverage level. The airbag mechanism will only be triggered upon movements of the underlying index that go against the direction of the product.
For example, if the underlying index falls by 20%, the airbag mechanism for a 3x Long DLC will trigger as the value of the DLC will go down with the fall in the underlying index but the airbag mechanism for 3x Short DLC will not be triggered because with the fall in the underlying index, this DLC will actually increase in value by 60% (3×20%)
The levels are set as 20% for a 3x DLC and 10% for a 5x DLC.
With an Air Bag, once the trigger of say 10% on a 5X Long STI DLC is hit, trading will be suspended for 30 mins.
Once resumed, the leverage returns will be taken from the point where trading restart.
So it is like the trading day gets shortened.
If there is a 10% drop, the DLC falls 50%, the DLC price changes from $2 to $1. Trading suspends and resume.
If there is no Air Bag, this is a 20% drop in the underlying index, the DLC would have been hit with a 100% drop. The DLC price changes from $2 to $1.
You die slower.
There is also something you should know.
While the Air Bag dampens the losses, it also means that should the price be volatile, the recovery will be less after the airbag event.
The same magnitude of recovery, will not recover your capital.
Speculators need to be qualified to trade SIP products
As DLC is a form of structured product that is deemed more complex by the SGX, it will require the investor to be eligible to trade with SIP products.
This means that the investor needs to have a finance education, working in the field of finance or previous trading experience.
If not, they would have to take some education modules and passed a test in order to be qualified to make use of DLC (you an do the test here at sgx.com/sip) .
How You Should Make Use of DLCs
With this information about DLC, are DLCs suitable for you?
Firstly, DLC to me, classifies as a financial instrument.
While it is important that you know DLC’s behavior, how you make money depends on your strategy for it.
Without a plan, be it based on technical analysis, or some other price analysis, event analysis, even with the most efficient tools, things will not work out well.
There is also a need to have a good risk management plan.
For example, if you deploy 100% of your capital in a single trade on DLC, thinking that the direction of the market will go in the way you anticipate, your returns could be magnified. However, there is equal probability the index will go in the opposite direction, and so will your losses.
Before you know it, your total capital is reduced to such an extend it will take a lot of good trades just to get back to break even.
The key for successful speculators is to
- choose when to get in
- whether to get in
- decide your course of action when the trade goes in your favor
- decide your course of action when the trade does not go in your favor
While DLCs air bag functionality limits your losses against huge intraday price moves, it might not be wise to bet a large amount of your total capital on a single trade. Position sizing is important, picking and selecting the trade as well.
Personally, I think intraday trading is a difficult game that only the rare few are able to do it successfully.
Despite that, some folks cannot run away from their animal instinct to bet.
You be glad to have a tool for that and after my explanation, a better idea how this works.
Here are some materials to extend what you know further:
This article was written in partnership with SGX. All views expressed in the article are the independent opinion of Investment Moats.
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