With the launch of the derivatives market in Kenya fast approaching, I would like to highlight or rather discuss briefly on a feature of interest to me and that is the derivative contract size.
A contract size is the quantity that can be delivered on a futures and options contract that is exchange traded. This contract size is standardized and varies depending on the commodity or instrument that is traded. The contract size also determines the KES value of a unit move in the underlying commodity or instrument
The contract size governs the minimum ticket size of a futures trade. Increasing it would mean that only 'richer' traders participate while decreasing it would mean that it makes it more affordable for 'regular' traders (like myself) to trade.
Expected derivatives contract size in the Kenyan market:
- Index - index points times 100
- Single Stock Future - 1 contract = 500 shares
- Forex - 1 contract = 1000
Minimum order value:
- Index Value = 3900 points * 100 = KES 390,000
- Single Stock Future Value = KES 17 (stock price) * 500 shares = KES 8,500
- Forex = USD/KES 101 * $1,000 = KES 101,000
Increasing the contract size:
This would limit trading to only those that can afford to trade in large amounts and that's why it would effectively target the 'richer' traders. However, this does not necessarily mean that these 'richer' traders are better at making money. What it does mean is that they are better 'placed' to handle a much larger loss of money in the market while majority of us 'regular' traders cannot.
For brokers and stock exchanges, this would be a red flag. Their reasoning is that it would be terrible for market liquidity. Well, there is evidence of this. Last year, the SEBI increased the equity derivative contract size from Rs 2 lakh to Rs 5 lakh which hit volumes hard. This is because 20%-30% of the turnover came from retail investors (which makes sense because the contract size was so low and thus attractive and affordable to them)
Why I think this is important to consider in future
I believe increasing the contract size makes sense especially for the Kenyan economy which is driven (more or less) by the spending power of the 'regular' folk. So when the 'regular' folk go crazy on speculating on this derivatives market our losses (and as such reduced spending power) hurt the economy. Currently, the middle class population in Kenya constitutes 44.49% of the total population and they form a powerful purchasing block.
Majority of those in the middle class income group rely heavily on their salaries yet the economy is not creating enough jobs to absorb the ever increasing young population.
The derivatives market does serve a useful purpose by providing risk management tools against various financial risks. However globally, this only accounts for approximately 5% of the traded derivatives.
Over 85% of derivative volumes are either speculative in nature (read: GAMBLING) or from dealers hedging speculative trades.
The gambling connection
Quick money has become the norm in Kenya and this is why there is a booming betting industry (read: GAMBLING) that has formed that makes billions of shillings from the misfortunes of many.
I once went to a casino to experience this world of quick money. I walked around the tables and since I had no idea what was going on - I just watched. First up, the Roulette game. The minimum entry to a game is a mere KES 1,000 and you can receive chips (what you use to play with) worth a minimum of KES 25 (40 chips).
Mind you 40 chips look a lot when you have them on the table (just picture it) and it creates some sort of confidence of having more thus making you believe you can win big. This boosts the gamblers ego (especially if they are on a winning streak - irrespective of how small. A win is a win)
Now, when the chips start to end the gambler thinks to themselves, "It's only KES 1,000 (or less since you are already in the game) let me 'buy' more chips because I know I will win it back and win so much more". And thus, the cycle continues. The intoxicating pull of a possible win is hypnotic and it doesn't help that the 'house' treats them extremely well providing free food and drinks throughout the day and night.
Parting note...
That's my concern. Most times derivatives trades aren't handled in the most ethical way. So it is highly likely there will be vultures in the market. All I am saying is, an increase in the contract size may be welcome as it may help keep the 'regular' traders away from unnecessary risks that will eventually be socially amplified.
FAQs
Over 85% of derivative volumes are either speculative in nature (read: GAMBLING) or from dealers hedging speculative trades. Quick money has become the norm in Kenya and this is why there is a booming betting industry (read: GAMBLING) that has formed that makes billions of shillings from the misfortunes of many.
What are derivatives in gambling? ›
Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds.
What are the 4 types of derivatives? ›
There are four main types of derivatives: forward contracts, futures contracts, options contracts, and swap contracts.
Are derivatives just bets? ›
Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an equivalent amount of underlying asset.
What are derivatives in simple words? ›
Definition of Derivatives
Derivatives are financial contracts, and their value is determined by the value of an underlying asset or set of assets. Stocks, bonds, currencies, commodities, and market indices are all common assets. The underlying assets' value fluctuates in response to market conditions.
What are the 5 examples of derivatives? ›
Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference, and index return swaps.
What are derivatives used for in real life? ›
Application of Derivatives in Real Life
It is also applied to determine the profit and loss in the market using graphs. Derivatives are applied to determine equations in Physics and Mathematics. The equation of tangent and normal line to a curve of a function can be determined by applying the derivatives.
What are the two most common derivatives? ›
Common underlying assets include investment securities, commodities, currencies, interest rates and other market indices. There are two broad categories of derivatives: option-based contracts and forward-based contracts.
What are the disadvantages of derivatives? ›
Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.
Does Warren Buffett use derivatives? ›
In spite of Buffett famously calling derivatives “weapons of mass destruction,” yes, he uses them.
Trading rising and falling markets
With derivatives, you can trade both rising and falling markets, meaning you can profit (or make a loss) even in a depressed or volatile economic environment. You'd go 'long' if you think the price of an underlying asset will rise; and 'short' if you think it's going to fall.
Is option trading basically gambling? ›
Successful options trading requires thorough research, analysis, and strategic planning. Traders often use technical and fundamental analysis, historical data, and market trends to make informed decisions. This contrasts with gambling, where outcomes are typically based on luck and chance.
What is a derivative for beginners? ›
A derivative is described as either the rate of change of a function, or the slope of the tangent line at a particular point on a function. What is a derivative in simple terms? A derivative tells us the rate of change with respect to a certain variable.
What is a derivative in layman's terms? ›
A derivative is a financial instrument whose value is derived from an underlying asset, commodity or index. A derivative comprises a contract between two parties who agree to take action in the future if certain conditions are met, most commonly to exchange an item of value.
What is the best explanation of derivatives? ›
The derivative of a function at a point is the slope of the tangent drawn to that curve at that point. It also represents the instantaneous rate of change at a point on the function. The velocity of a particle is found by finding the derivative of the displacement function.
What is an example of a derivative in trading? ›
Derivatives can be a very convenient way to achieve financial goals. For example, a company that wants to hedge against its exposure to commodities can do so by buying or selling energy derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by purchasing currency forward contracts.
What is an example of a derivative option? ›
Examples of Derivatives
The current Exchange rate is 1 USD = 80 INR. The exporter decides to enter into a currency futures contract to sell USD and buy INR at the current exchange rate for the future date. Each futures contract represents a specific amount of foreign currency.
What does derivatives in the money mean? ›
In the money (ITM) is defined by an option's state of 'moneyness' – the underlying asset's status when compared to the price at which it can be bought or sold (its strike price).
