A derivative is a financial instrument whose characteristics and value depend on an underlying asset. The asset can be an equity, currency, bond, interest rate, commodity or even the weather.
What are the different types of derivatives instruments?
Derivatives can be broadly classified into four categories:
What are the types of derivatives being traded on NEXT?
NEXT currently offers equity futures contracts. These are classified into: Equity Index Futures and Single Stock Futures.
What is a futures contract?
- Simply put, a futures contract is an agreement to exchange a pre-specified asset at a pre-specified price on a pre-specified date in the future.
- The futures contract can be bought or sold on the NSE just like any other security.
- Futures contracts require either physical delivery of the asset or settlement in cash.
- All futures contracts on NEXT are settled in cash. This means that you realise your profit or loss in cash rather than delivering or receiving the physical asset.
What is the structure in the derivatives market?
- At the top of the hierarchy, is the Clearing House (NSE Clear), which is a wholly owned subsidiary of the NSE.
- The Clearing House novates all transactions and is therefore the legal counterparty to both parties. The Clearing House essentially becomes the buyer to every seller and seller to every buyer and ensures that all parties fulfil their obligations.
- Clearing Members are under the Clearing House. They are either banks or financial institutions that are responsible for clearing, settlement and risk monitoring of Trading Members.
- Clients open accounts with Trading Members who then execute orders on their behalf i.e. buy and sell derivative contracts for them.
How does NEXT manage risks associated with these contracts?
- Investors require Initial Margin to enter into any futures position. This is a minimum (good faith) deposit required from an investor for the duration of an open contract. These margin requirements apply to both the buyer and seller.
- Initial Margins for each contract are ordinarily reviewed and announced every quarter. For more information see Market Notices
- Daily profits or losses on an investor’s position are either debited from or credited to the investor’s trading account.
- If the investor’s trading account has insufficient funds to cover a loss, the investor will be required to add sufficient funds to the account or to close out (exit) their position.
- The regular administration of margins prevents participants from accumulating large unpaid losses which could impact the financial positions of other market users (systemic risk).
What is Variation Margin?
- Unlike the cash market (equities market) where profits or losses re only realised when the instrument is sold, trading on NEXT means that investors receive or pay profits or losses on a daily basis.
- This payment is known as the Variation Margin and is equal to the difference in the value of the investor’s position from day to day.
How does one invest on NEXT?
- NEXT contracts can be bought and sold through the Derivatives Trading Members of the NSE.
- In order to open a trading account, the investor should be onboarded by an approved Trading Member. This involves the completion of various documents including member-client agreements, Know-Your-client (KYC) and risk disclosure documentation.
- To begin trading, the investor must deposit cash and/or other collateral with the Trading Member as stipulated by the Trading Member.
Which brokers are approved derivatives Trading Members?
What are the benefits of trading derivatives on NEXT?
- Derivatives are more flexible than the underlying instruments while the value is still based on the price of the underlying assets.
- Derivatives contracts can be leveraged. This means that you can trade a position that is larger than the amount of cash required upfront.
- Derivatives can be used to protect against adverse price movements. You can therefore use derivatives to protect your existing portfolio of shares for example.
- Derivatives are cheaper to trade compared to trading shares.
What is the difference between the derivatives market and the cash/spot market?
|Spot Market||Derivatives Market|
|The securities have an infinite lifespan.||The contracts have an expiry date.|
|Full cash or value of shares paid upfront.
For example, a trade worth KES 100,000 will require KES 100,000 upfront.
|A good faith deposit (margin) is paid upfront.
For example, a trade worth KES 100,000 will require approximately KES 10,000 upfront.
|Profit/Loss is realised after exiting the position.||Profit/Loss realised on a daily basis.|
How are these contracts closed out?
- All NEXT futures contracts have closeout dates on which the contract expires. The futures contracts are named according to their expiry month. For example, 16 DEC21 SCOM represents a Safaricom futures contract that will expire on 16th December 2021.
- NEXT Equity Index Futures and NEXT Single Stock Futures expire on the third Thursday of the relevant expiry month. If that day is a holiday, then expiry is on the previous business day.
- On the expiry date of a particular contract, the contract is terminated by the exchange and it ceases to exist. The exchange then refunds Initial Margins to investors.
How is Clearing and Settlement done on NEXT?
- The Clearing House (NSE Clear), through appointed Clearing Members computes the obligations of investors who have traded through Trading Members. These obligations detail the amounts an investor needs to pay or receive in terms of margins. The computation of these obligations is the “clearing” process. The actual flow of cash to satisfy the obligations is the “settlement” process. The clearing and settlement process is performed daily for all trades executed on NEXT.
- Settlement is done on a T + 1 basis. This means that parties to a trade satisfy obligations arising from the transaction one day after the trade is executed. All futures contracts on NEXT are settled in cash on a daily basis.
What are the current futures contracts offered by the NSE?
- The NSE currently offers futures contracts based off an equity index and a select number of stocks listed at the Exchange
- At the moment, the specific futures contracts are:
- NSE 25 Share Index (N25I)
- Mini NSE 25 Share Index (25MN)
- Single Stock:
- Safaricom Plc (SCOM);
- KCB Group Plc (KCBG);
- Equity Group Holdings Plc (EQTY);
- ABSA Bank Kenya Plc (ABSA);
- East African Breweries Ltd (EABL); and
- British American Tobacco Kenya Plc (BATK).
What does 1 futures contract represent?
- Equity index futures
- NSE 25 Share Index – 1 index point represents KES 100. Therefore, if the contract value changes by 1 point, you will gain or lose KES 100.
- Mini NSE 25 Share Index – 1 index point represents KES 10. Therefore, if the contract value changes by 1 point, you will gain or lose KES 10.
- Single stock futures
- For stocks trading below KES 100, 1 contract represents 1,000 underlying shares. Therefore, if the contract value changes by KES 1, you will gain or lose KES 1,000.
- For stocks trading above KES 100, 1 contract represents 100 underlying shares. Therefore, if the contract value changes by KES 1, you will gain or lose KES 100.
What is the selection criteria for single stock futures?
In order to be eligible to trade as a future, the underlying stock:
- Has to be listed on the NSE;
- Has to be a constituent of the NSE 25 share index;
- Must have traded an average daily turnover of KES 7,000,000 for six months prior to review; and
- Must have a market capitalization of at least KES 50 Billion
How often does the NSE review stocks to determine whether they merit to be listed as futures contracts?
The NSE undertakes quarterly reviews of stocks to determine whether to list or delist them as futures contracts.
Does the 10% price limit rule apply to futures contracts?
Yes. The rule applies to futures contracts in the same way it applies to the equities market. Futures prices may move a maximum of 10% during the trading day unless the NSE communicates otherwise.
Does an investor have to hold a futures contract until maturity of the contract?
No. An investor can trade and offload their futures contract at any point in time during the duration of the contract. This could even be done on an intra-day basis where the investor buys and sells contracts on the same day.
Can one benefit from futures contracts if the market is going down?
Yes. The derivatives market offers dual opportunities for investors to profit when the market goes up (by initiating a buy/long position) or when the market goes down (by initiating a sell/short position).
Is there an online trading platform?
Yes. The NSE has provided an online trading platform for the derivatives market. Investors may request view access from their Trading Members. The Trading Member may also grant trading rights to the investor at their own discretion.
Will I receive dividends from futures contracts?
No. Futures contracts do not represent ownership of the underlying asset therefore investors do not receive dividends or voting rights by virtue of holding single stock futures. Dividends are accounted for in the daily valuation of the futures contracts.
What is the minimum amount of capital I need to start trading?
- This depends on the futures contract you would like to trade.
- For example, to trade one ABSA futures contract you will require a minimum of approximately KES 1,500 while a single Safaricom contract will require approximately KES 4,600 and one Mini NSE 25 Share index contract requires approximately KES 4,800.
- See Market Notices for an updated list of margin requirements.
What time is the market open?
- The futures market is open for trading from 9:00 am to 3:00 pm on Monday to Friday except public holidays.