What are Daily Leverage Certificates (DLCs)?
It will be easier to explain the term in reverse order; ‘certificates’, ‘leverage’ and ‘daily’.
Certificates
Certificates are a class of securitised financial instruments.
They are financial derivatives that allow investors to conveniently gain exposure to an underlying asset.
They are bi-directional, and investors can use certificates to express both long and short ideas.
Finally, certificates are traded on the stock exchange and hence can be bought and sold easily through a regular stock brokerage account.
Leverage
DLCs are leverage products.
For the initial launch, the maximum leverage would be capped at 5x.
What does that mean for an investor? How volatile could the returns be?
Based on the price movements of the MSCI Singapore Index (MSCI Singapore) and the Hang Seng Index (HSI) in 2016, the 5x DLCs daily returns will range between -15% to +15% for the MSCI Singapore and -20% to +20% for the HSI.
Daily
The performance of the underlying asset is concluded and reset at the end of each trading day.
This daily performance reset sounds like a simple feature but it will cause large variations in your returns when you hold the Daily Leverage Certificates over a few days.
From the example below, the underlying gained 4.05% after 3 days of trading. In a trending market, the DLC will return 21.3% for the investor.
However, should the market be volatile and the underlying be subject to wilder price fluctuations, the DLC will only return 15.5% despite the underlying having also gained 4.05%.
In other words, DLCs returns are very dependent on the daily closing price of the underlying. The longer an investor owns a DLC, the greater the degree of variation and larger the uncertainty on the performance.
SGX is the first in Asia to introduce DLCs
DLCs have started trading on the SGX since 17 Jul 2017. Société Générale, a French bank with experience launching DLCs in Europe, will issue 10 DLCs for a start:
- MSCI Singapore Index 5x
- MSCI Singapore Index -5x
- Hang Seng Index 3x
- Hang Seng Index -3x
- Hang Seng Index 5x
- Hang Seng Index -5x
- Hang Seng China Enterprises Index 3x
- Hang Seng China Enterprises Index -3x
- Hang Seng China Enterprises Index 5x
- Hang Seng China Enterprises Index -5x
A typical counter name would be presented as such on the SGX website or your trading platform:
How Daily Leverage Certificates Could Be Used
DLCs are targeted at sophisticated active investors and traders who are used to trading leveraged derivatives. The product is classified as a Specified Investment Product (SIP). Investors must be qualified in order to trade it.
i) Event Driven
Due to the leverage and the reset feature, DLCs are very suitable for traders to take up positions on a planned event. This is especially so when the markets are expected to react forcefully to the outcome.
When the UK went to the polls to determine their future in the EU, when the Americans election results were about to be announced, and during all Federal Open Market Committee meetings, there were huge movements in the financial markets.
With the DLCs, traders now have a tool that would give them better returns if they were to get their predictions right.
ii) Short Term Hedging
Some investors may want to hold on to their stocks but are afraid that a looming event may aversely affect the markets. They could buy inverse DLCs before the event to hedge their positions.
If the market takes a dip, profits from the inverse DLCs could offset part of the losses from their stock holdings. If the market enjoys an upturn, the stock holdings gain in value while the DLCs would make losses.
Some liken it to taking up an ‘insurance policy’ on the portfolio.
iii) Strong Directional Bias
The market may appear very bullish or bearish for a given period. If an investor believes the momentum would continue in the short run, he might want to ride on the trend and enjoy the compounding effect over a few days.
During the bull run of 2007 or the bear market in 2008, the index can go in one direction for many consecutive days without reversing. DLCs would come in very handy and prove to be very profitable in such market conditions.
iv) Intraday Index Trader
A day trader who bets on intraday price movements of the indices would also find DLCs useful.
Benefits of DLCs compared to similar products
Straightforward and Transparent
You can trade long and short with leverage using other products like Structured Warrants and Contracts For Difference (CFDs).
However, Structured Warrants are affected not just by the movement in underlying index, but also the implied volatility and time to maturity among other things. It is complex and you can still lose money even if you get the direction right.
CFDs are not traded on the exchange and are margined products which mean you can potentially lose more than your invested capital.
DLCs have an advantage over these two derivative products by having a more straightforward and transparent pricing structure and your loss is also limited to your invested amount.
Compounding Effect
DLCs are special because of the daily reset of performance. This results in greater returns (and losses) than other levered products, when held over a few days.
Airbag Mechanism
DLCs have a protection feature in case the underlying index price changes become too excessive. This is not present in other derivative products and is unique to DLCs.
The airbag would be triggered if the underlying index moved 10% for a 5x DLC and 20% for a 3x DLC. When triggered, the DLCs will stop trading for 30 minutes and resume with an intraday reset. The benefit is that it would slow down the rate of loss.
The converse is also true, it would also recover less of its value if the market rebounds.
Risks and what DLCs should not be used for
Daily Leverage Certificates are more complex than a stock but simpler than a Structured Warrant. Here are some of the risks you should be wary of
- DLCs are leveraged products and hence you may lose all your capital if the trade goes against you
- DLCs are intended to be traded intraday or over a few days to capture short term trends but are not meant to be held for the long term. This is because holding the DLC over a long period of time will result in variation of your return from the leverage factor that is embedded within the product and also incur fees at the same time
- Getting the direction of the underlying index right is crucial to your performance and it is often a challenge for most investors
Interested to find out more about DLCs? Visit sgx.com/dlc or speak to your broker for more information!
The publication of this article was sponsored by Singapore Exchange. The author aims to share his views about how he would find the product useful and he is not recommending you to buy. You are responsible for your own investment decisions and their outcomes.