Wednesday, August 4, 2021
business

What are Stock Futures and why are they important?

The Nigerian Exchange Limited (NGX or The Exchange) recently announced that “it has received approval for seven derivatives contracts from the Securities and Exchange Commission (SEC) on Monday, 28 June.” According to the announcement, the approval means that “NGX is inching closer to the launch of West Africa’s first Exchange Traded Derivatives supported by NGX Clearing in the risk management process.”

The announcement went further to point out that the approved stock futures are “Access Bank Plc Stock Futures, Dangote Cement Plc Stock Futures, Guaranty Trust Bank Plc Stock Futures, MTN Nigeria Communications Plc Stock Futures, Zenith Bank Plc Stock Futures, NGX 30 Index Futures, and NGX Pension Index Futures.”

A good look at the list of approved contracts shows that the approval is for both Singe Stock futures (SSF) as well as Stock Index futures. What is the difference?

Single Stock futures are futures contracts on individual stocks while a Stock Index futures is a futures contract on a basket of stocks contained in an index.

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What are futures?
What are futures even, you may ask?

A futures contract is an agreement to buy or sell “something” at a future date at an agreed-upon price. With reference to the above listed approved contracts, the “something” might be any of those contracts. At the expiration of the contract, the buyer must pay the agreed-upon price and the seller is obligated to deliver the contracted shares or agreed quantity of the “something.”

Why trade futures?
Futures contracts enable investors and fund managers to secure a known or specific price for an asset and therefore, help them to protect or hedge against the ups and downs of asset prices. For example, assume that you expect to be paid your annual bonus by the end of next month, which you intend to invest in the stock market on Dangote Cement Plc. Again, you are afraid that the price of Dangote Cement will increase by the time you receive the bonus, so to hedge against such price increase, you buy a futures contract on Dangote cement, which grants you the opportunity to buy Dangote Cement Plc stock at an agreed price. So, if by the time you receive the bonus, the price of Dangote Cement has actually gone up, you gain by buying it at the already agreed price per the futures contract.

On the other hand, if the price of Dangote goes down, you can enter into an offsetting futures trade that helps you close out of the futures by holding both the long and short end of the futures contracts.

Advantages of futures
Why should investors get excited about the introduction of stock futures in Nigeria and of course, West Africa?

One of the reasons is that futures trading increases the liquidity of the stock market. Market liquidity, on the other hand, gives investors and fund managers greater flexibility in allocating and reallocating their funds thereby leading to more efficient use of capital resources. As noted already, futures help investors to hedge their risk and allows speculators to profit from the gyration of asset prices.

Matters arising
Although the Stock Exchange just announced the approval, lots of information is required to know how things will play out. Among the information are, the contract size, whether margin will be required and if so at what percentage, the life cycle of the futures, minimum price fluctuation (if any), etc.

Until such information is out in the open, investors should brace for a change. Most importantly, the Exchange should educate and sensitize the intended users of the futures contracts on the product so as to elicit the required and even greater level of motivation for the new financial product.

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