The Singapore Exchange (SGX) recently launched a new product offered by Societe Generale that will be available for trading on their securities market. Called the Daily Leverage Certificate, this product will be the first-of-its-kind in Asia but one of the fastest growing trading products in Europe. Trading of the products will commence on 17 July 2017.
Before you consider buying into the product, it’s important for you to first understand how this unique product actually works.
What Exactly Is A Daily Leverage Certificate?
The Daily Leverage Certificate offers investors fixed daily leveraged exposure to a number of leading Asian indices. It will allow investors to trade and capture amplified returns on short-term market movements.
In the case of the Daily Leverage Certificate (DLC), the underlying indices that the DLC will track are the three key indices in the Singapore and Hong Kong exchanges:
- MSCI Singapore Index (SiMSCI)
- Hang Seng Index (HSI)
- Hang Seng China Enterprises Index (HSCEI)
What the DLC does is that it increases your exposure level to the indices you are trading (when buying a 5X DLC priced at $2 you actually have $10 market exposure). Traders have the flexibility of taking either long or short positions. If they think prices will go up, they buy long DLC. If they think prices will go down, they buy a short DLC.
Contrary to for example structured warrants, the pricing on a daily basis is fairly simple as it is not impacted by factors like implied volatility or time decay.
How It Works
For example, if you think the Hang Seng Index will go up, you can buy a DLC that gives you either a 3 times (3x) or 5 times (5x) leverage. That means your returns will be amplified three or five times the daily returns of the index you invested in. Of course, the same goes for any losses incurred if the index moves against your position.
In other words, what the Daily Leverage Certificate does is that it magnifies your returns (or losses) based on the underlying asset that you are tracking and the position that you have taken.
Long Term Compounding Effect
At first glance, this may appear straightforward. You buy a DLC that gives you a 3x or 5x exposure of the index that you are trading. You expect to make 3x or 5x the return (or losses) based on the changes in the index.
However, bear in mind that the returns offered by the DLC is designed such that it tracks daily performance of the underlying asset. What that means is that if you buy and hold a DLC beyond one day, your returns may significantly deviate from the 3x or 5x that the DLC is supposed to generate. That’s because the DLC is designed to be traded on an intraday basis, and holding it beyond one day will see a compounding effect coming into play.
Here’s an example of how it works.
Illustration 1 – Volatile Market
When the market is extremely volatile (as seen from the table above), the actual returns from the DLC may vary significantly from what a trader expects to receive. That’s because the base value of how returns are tracked will be reset each day so a new base is used at the start of each new trading day, rather than your original base.
For example, in the table above, returns of the underlying asset is 4.05%. Based on a 5X exposure, returns for the DLC should have been 20.25%. However, actual return is only 15.50%. That’s because the DLC tracks the returns of an asset daily. When the daily returns are compounded over a period of a few days, the actual returns may vary, nonetheless looking at daily performance on a daily basis you will see that it is 5 times the performance of the underlying.
In a trending market, this compound return will actually work in favor of the trader.
Illustration 2 – Trending Market
While the underlying asset in both illustration 1 & 2 have the same final returns (4.05%), the returns on the DLC is significantly different.
For illustration 2 (trending market), returns of the DLC, which is 21.30% and that is actually more than 5 times the return of the underlying due to the compounding effect. This is in contrast with illustration 1 (volatile market), where actual return of the DLC is lesser than 5 times the underlying.
In summary, the DLC is not a suitable product to hold on to for a long period or in a volatile market. However, this characteristic also makes the DLC ideal for traders to enjoy short-term gains when the market is trending.
What Happens If The DLC Loses A Huge Chunk Of Its Value During Extreme Market Conditions?
One of the risk factors that traders have to look out for for when trading leveraged produds is the possibility of losing more money than their initial deposit during extreme market conditions.
For the Daily Leverage Certificate, there are mechanisms in place that are in place to slow the rate of loss in extreme market conditions and limit losses to the mount invested. One key feature worth noting is the air bag mechanism.
The air bag mechanism can be thought of as a circuit breaker. It kicks in immediately if the underlying falls below a certain level on any given day.
What this basically means is that if the underlying of a 3X DLC drops by 20%, the air bag triggers an automatic intraday reset of the underlying index. This reset takes place over a short period of 30 minutes. Following the reset, changes in the underlying index will be based on the new observed level.
Airbag Mechanism Means You Can’t Lose More Than Your Investment
Typically when leverage is being used for investment products, there is always a risk that losses may exceed deposits. For example, if you buy a stock on a 5:1 margin (e.g. $100,000 position with $20,000 outlay) and the stock falls below $80,000, you would not only lose your $20,000, but also be required to top up the additional loss sustained.
With the DLC, there is no such risk because of the Airbag Mechanism built into the product. For example, if leverage of 5x is used and the underlying asset losses 10% of its value, the air bag trigger will come into effect to automatically trigger an intraday reset of the underlying index.
If the 5X DLC is $2 and loses half of its value due to the underlying index falling 10% for the day, a reset will automatically be triggered.
Who Will Find The Daily Leverage Certificate Useful?
It goes without saying that the daily leverage certificate isn’t a product that is meant for everyone. It’s designed specifically for sophisticated retail investors who want to actively trade, and make higher returns from the daily movements of the benchmark indices.
At the same time, investors need to be Specified Investment Product (SIP) qualified in order to trade the DLCs. Those who are less knowledgeable or do not have high risk tolerance should avoid the product. Investors should fully understand their exposure to the risks involved before they start trading.
If you want to find out more about the Daily Leverage Certificate before you start buying it, you can read up more about it on a dedicated SGX webpage at sgx.com/dlc. You also can speak to your broker to find out more on the product, its risks and how you can qualify to trade SIP.
The publication of this article was sponsored SGX. All views expressed in the article are the independent opinion of DollarsAndSense.sg
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