In the complex world of trading financial markets, nothing is always guaranteed. Prices rise and fall depending on investor sentiment, and money changes hands several times each second every day.
Amidst the market volatility and uncertainty surrounding future events, derivative contracts have become the most common way in which investors manage risk while protecting their assets. These derivative instruments enable investors to diversify their investments and deploy funds more efficiently.
Trading derivatives can exponentially increase your returns from investing and is considered one of the best ways to take your investing to the next level. Using derivatives, you can add leverage to your trades and even speculate on the future price of an asset.
In this guide, we break it down on how an investor can get started trading derivatives at the Nairobi Securities Exchange. We explain the different types of derivatives available for trading on the local exchange and how to get started.
What are Derivatives
In the most basic definition, derivatives are financial contracts which obtain (derive) their value from something else, known as underlying securities. In this case, underlying securities can be stocks, bonds, currency, indices, commodities, exchange rates, interest rates etc.
There are four types of derivatives instruments which are futures contracts, forward contracts, options contracts, and swap contracts.
Derivatives Trading in Kenya
Locally, in the Kenyan capital markets, equity futures contracts are currently available for trading on the Nairobi Securities Exchange (NSE) and the specific futures contracts are Equity Index Futures and Single Stock Futures.
A futures contract is an agreement to exchange an underlying asset at a pre-agreed price on a future date which creates an obligation. Futures contracts are made through an organized and regulated exchange (NSE Derivatives is regulated by the CMA) rather than being negotiated directly between two parties.
History Of Derivatives in Kenya
In the early 2000s, the Nairobi Securities Exchange (NSE) and the Capital Markets Authority (CMA) began to formulate plans to reform the capital markets industry in Kenya. Part of the reforms included the reorganization of the Exchange to include the derivatives markets under the Futures and Options Market Segment (FOMS).
The NSE conducted a derivatives market pilot program between July and December 2018 where it gained valuable insights. The Exchange was guided by the highest global standards used by the Principles of Financial Market Infrastructures (PFMI) and the International Organization of Securities Commissions (IOSCO).
The CMA, Kenya’s capital markets regulator, in June 2019 granted the Nairobi Securities Exchange the first license to operate a derivatives markets. This followed the gazettement of the CMA Derivatives Regulations in 2016.
After this industry preparation, the Kenyan derivatives market, known as the Nairobi Derivatives Market (NEXT) went live in July 2019 and was the first of its kind in East Africa, and the second in Africa after the Johannesburg Stock Exchange (JSE).
The NSE Derivatives Markets commenced by trading of equity index futures based on the NSE 25 share index and single stock futures based on the most liquid companies at the NSE i.e. Safaricom, Equity Holdings, and KCB Group, Absa, EABL and BAT. In addition to the aforementioned products, the NSE Derivatives Market aims to grow the list of derivatives traded in the segment in the coming years to include commodities.
NSE Derivatives Market Participants
The NSE Derivatives Market (NEXT) consists of four main players; a Clearinghouse, Clearing Members (Banks and Financial Institutions licensed by CBK), Trading members (Brokers and Investment Banks), and Clients (Institutional and Individual Investors), who can either be speculators, hedgers, or arbitrageurs.
Prerequisites for Derivatives trading
- Trading account: This is the account through which you conduct trades. You can open an account with a licensed derivatives Trading Member of the Exchange. The Capital Markets Authority (CMA) has approved 7 licensed derivatives markets Trading Members i.e. Faida Investment Bank, Genghis Capital, Kingdom Securities, NCBA Investment Bank, Standard Investment Bank, AIB-AXYS and Sterling Capital.
- Margin maintenance: When you purchase futures contracts you are required to deposit a percentage of the value of your outstanding position, irrespective of whether you buy or sell futures. This mandatory deposit is called an initial margin. An investor is expected to deposit the initial margin upfront to be in order to guarantee contract fulfilment in the derivatives markets. This margin is levied on the value of the contract that you buy or sell. The amount required as initial margin is decided by the NSE depending on the volatility of a particular derivatives contract.
Suppose you are optimistic about Safaricom (SCOM) and believe the company will appreciate in value over the next three months or so.
Through your broker, you could purchase 1 SCOM contract on the derivatives market. All SCOM futures contracts represent 1,000 shares so if SCOM futures are currently trading around KES 36.00, then the value of 1 contract is KES 36,000 (36 x 1,000).
In order to enter this trade you will be required to deposit initial margin with the Exchange. This is approximately 10% for SCOM contracts* meaning that you will be required to have at least KES 3,600 available in your derivatives trading account.
If the market moves in your favour and the value of SCOM contracts is increasing, you will gain KES 1,000 for each KES 1 increase in the value of SCOM contracts. This will be credited to your derivatives trading account on a daily basis.
If the market moves against you and the value of SCOM is falling, you will lose KES 1,000 for each KES 1 decrease in the value of SCOM contracts. This will be debited from your trading account on a daily basis.
The average investor who wants to begin trading derivatives will need to do so through a broker that specializes in futures. Since derivatives are considered niche financial product for retail investors, those interested in trading them may need to do so through a brokerage that specializes in futures.
Trading Members of the NSE derivatives markets may trade on their own account in order to take up proprietary positions.