Trading in futures contracts on DGCX

He started trading in futures contracts, mostly gold, on Dubai Gold and Commodities Exchange with an initial amount of Dh20,000. That was two years back and until today Vedran Dedic's total investment has been about Dh150,000.

The 29-year-old Briton's reasoning to invest in this type of derivatives is simple: it brings in more returns compared to some of the other investment options.

"The returns that you get on investments by trading in futures contracts is much greater over a longer period rather than putting your money in a savings account or something similar," says Dedic, who is group sales head of a media company in Dubai. Over the period, he has seen his money quadruple.

It's not just about getting decent enough returns on the investment, but futures contract trading is a way for traders and retail investors to hedge their commodities and currencies to insulate themselves from the fluctuations in prices and rates. Whether it is for investment or hedging, investors and brokers emphasise on being informed and educated about the ways of any type of derivatives trading and the high leverage and risks that come with it.

In simple terms, a futures contract is a standardised and regulated agreement between a buyer and seller for the exchange of a specific amount of commodity at a specific price and date. The underlying assets on offer on the Dubai Exchange are: gold, silver, oil, steel bar and several currencies, including euro, British pound, Japanese yen, Indian rupee—with each having their own standardised contract specifications.

Gold futures volume, which represent the largest product traded on the Exchange, is up by 15 per cent this year, compared with the same period last year. Volumes of euro and British pound have increased by 59 per cent and 315 per cent respectively.

Futures contract does away with physical transaction. And that's a great advantage to have for both buyers and sellers, whether for the purpose of hedging or investing for a return. Otherwise you had to be carrying kilos of gold or barrels of oil to your home or to your warehouse and safely store it.

But it's not only that. It also allows small investors to put in just a fraction of the total contract size, which can be out of their reach. Each single contract size is quite big to be out of reach of retail investors (see table).

The futures contract deals are done by depositing a small part of the full value of commodity called margin (as fixed by the Exchange)—for example, $1,500 for gold, for oil it is $4,500—and the transaction is done on the Exchange, which acts as counterparty risk manager. Margin deposits vary for each underlying asset (see table). All futures contracts are highly leveraged because of this facility of low investment against the full value.

So, if you bought gold at $1,235 an ounce and, in three months, the future delivery date, it falls to $1,225, you have lost $10 on an ounce. The total loss is calculated on the size of the entire contract, which is 32 ounces (equal to one kilogramme), which makes it $320, the amount which you have to give to the buyer. The Exchange, as the counterparty risk manager, takes out $320 from the margin deposit of $1,500 for the gold contract.

The reverse happens when price of gold goes up by $10 an ounce. The gain calculated is based on the entire size of the single contract. The return on investment (ROI) is $320 on $1,500, a good 21.33 per cent.

"In this sense, it's a twin edged blade," says Pradeep Unni, senior research analyst at Richcomm Global, a derivatives broker registered with DGCX.

Its appeal as a hedging instrument makes futures contract trading an important strategy for bigger institutional clients, such as gold traders and manufacturers. Dubai-based gold manufacturer and trader Rajil Pahuja knows the benefits of hedging too well.

Hedging on the euro and Indian rupee has helped him save on his purchases. Both the currencies have been fluctuating in recent months.

"Not only do we source from India, but we do from Europe too," Pahuja says. "With the euro going down, if I would have taken delivery upfront in January it would have been at rates of $1.35/$1.36 and now it is $1.19. I have saved around 13 cents." And here we talking about high volumes—50 contracts on average, each worth 50,000 euros.

Also, a futures contract offer traders like Pahuja an instrument for price risk management, mainly for protecting his inventory risk. As a trader, he has tens of kilos of gold in store. If the rate is headed down, the entire inventory will lose value. To avoid that, he hedges the risk by trading in futures.

On purchases, he has saved about 15-20 per cent. However when it comes to selling, Pahuja wouldn't recommend a risk of more than five per cent.

Though futures contracts have set expiry dates, an investor can continue to hold on to any product for any time frame by simply rolling over the contract from one month to next month. The process is simple and can be guided through by the broker. Alternatively, DGCX does offer delivery of physical commodity on a few contracts.

Also, with short selling allowed, one can benefit from a downside move in prices. If an investor thinks that the price of gold is likely to come down, he can sell few contracts first and book profits when markets go lower.

Futures investors have to open their trading account with a DGCX registered broker. An accounting opening document as prescribed by the DGCX has to be signed and the investor also needs to provide supporting documents such as a copy of the passport, bank statement, address proof and a photograph. Once the account is opened, trading can begin after funds have been credited to the account.

Choosing brokers

On choosing brokers, says Pahuja, 31, investors have to make sure that they utilise the services of those who have been trading long term—the number of years they have put in. Also one should choose firms that have carved out a reputation for themselves in the market here and elsewhere where they have a branch. Background checks of individual brokers and the company are absolutely essential, he says.

Trading on derivatives on DGCX using the services of a broker such as Richcomm, the minimum investment amount ranges from $5,000 for gold to $10,000 for oil.

"Generally we begin with $5,000 on gold and that's because it gives us some room on mark to market daily profit loss. If someone invests in gold today at $1,235 and tomorrow it goes to $1,200 [three months down the line] I should not be chasing him for margins," Unni explains.

As for the industry standards for commissions and fees, it varies, but it is usually less than one per cent on a single contract. Discounts are offered on higher volumes. Price volatility and the growing attractiveness of commodities and currencies as an asset class have increased the level of interest from all market participants, including the retail segment, says Eric Hasham, chief executive of DGCX.

"Currently, participants on DGCX comprise of a healthy mix of retail as well as institutional players, although the later accounts for a larger part of the volume traded on the Exchange."

Every trade carries a risk, says Unni.

"You have to have sufficient room to play with and the risk level varies from trader to trader. For the high volume traders it is sometimes as high as 15 to 20 per cent," Unni explains. He however is quick to point out that we have a risk point or what is stop loss in each trade depending on the risk toleration level of each investor.

Dedic doesn't trade at all when the market goes down. When the market went bad and gold dropped to $1,080 in February, he simply walked away and did not re-enter for about a month.

"I have over the years experienced the highs and lows. However, every time when it went down, a very small amount has been sliced off. Due to that reason I have been quite happy with the longer term smaller turnovers. I find myself quite fortunate to be in that position," says Dedic, who has 60 per cent of his portfolio invested in futures contract, largely in gold.

Education

It's not just about staying away from the market when it goes down. Investors and brokers insist that those trading futures contracts must be educated and informed all the time. Also, this is a long term play and there are risks associated with such trading as there are with any other investing, including in equity markets.

"You have to be a wise investor," says Dedic. "You have to be patient and make sure that you look after your investments. Once the money has gone in there, read the market, understand the market, don't just be blind to it by saying that what's the turnover."

He discourages investors who are impulsive. "Just tell yourself that you are going to be playing for a longer period of time. So let it run its course. That's the best way to go about it. And you have to be wise enough to know when to walk away. You have to be calculating at times," Dedic says.

The importance of educating oneself is underscored by both investors and brokers. Pahuja, who has been trading since 2008, has taken training courses offered by Richcomm and today trades on his own.

"Sometimes even the broker gets it wrong and if you are educated enough, it might help to point that out to your broker," he says.

DGCX collaborates with members to conduct workshops for retail investors to introduce them to futures products and enhance their trading knowledge.

"The exchange plans to continue organising more such programmes in the future," says Hasham.

Dedic, who started using the services of Richcomm since the past two months, had been trading on his own before. He has been educating himself in the intricacies of futures contract trading for years.

"I did quite a lot of research on it before I went in," he says. "I have done it in Europe before coming to Dubai."

Unni points out that there are lot of prospective clients who come in with a high amount and ask for the return on investment, without bothering to know how it works. "If you tell them returns might vary between 5 and 10 per cent in about three to four months, they say ‘ok, great, it's so much more than bank savings.' They are happy and simply trust us with their investments, which are big amounts," he says.

This kind of attitude is the wrong way to go about, feels investors and brokers.

"Investors should be educated to track their own investments," says Unni. Brokers such as Richcomm Global send out a daily report to all its clients.

At the end of the day, Dedic says, one should invest the amount he or she can afford to lose.