Frequently Asked Questions 
18/01/2011 
 

Chapter 5

Market Operations and Trading


5.6

Derivatives Market Operations

 

5.6.1

What kinds of investors are suitable for trading in futures and options? 

Futures and options are not for all investors given their higher inherent risks than many other products. Investors should consider their tolerance for market volatility and losses, and consult their brokers or qualified financial advisers to see whether futures and options fit their personal needs. 

 

5.6.2

What are the risks to be considered before trading in futures and options?

There are a number of risks inherent in futures and options trading. Some major ones are summarised below, but the information is by no means exhaustive. Investors should make sure they understand the nature of a contract and the inherent risks before trading.

i. Futures

The “leverage” effect brings substantial risk

The amount of initial margin is small relative to the value of the futures contract so that transactions are 'leveraged'. This may work against investors as well as for investors as a relatively small market movement will have a proportionately large impact on the funds invested or to be invested. Investors may therefore sustain a total loss of initial margin funds and any additional funds deposited with brokers to maintain their positions. If the market moves against their positions or margin levels are increased, investors may be called upon to pay substantial additional funds on short notice to maintain their position. If they fail to comply with a request for additional funds within the time prescribed, their positions may be liquidated at a loss and they will be liable for any resulting deficit.

Risk-reducing strategies may not be effective

The placing of limit orders or stop-loss orders may not be effective because market conditions may make it impossible to execute such orders. Strategies using combinations of positions, such as 'spread' positions may be as risky as taking simple 'long' or 'short' positions.

 

ii.

Options

Variable degrees of risks

Purchasers and sellers of options should familiarise themselves with the type of options (i.e. put or call) which they contemplate trading and the associated risks. Investors should calculate the extent to which the value of the options must increase for their position to become profitable, taking into account the premium and all transaction costs.

The purchaser of options may offset or exercise the options or allow the options to expire. The exercise of an option results either in a cash settlement or in the purchaser acquiring or delivering the underlying interest. If the purchased options expire worthless, investors will suffer a total loss of their investment which will consist of the options premium plus transaction costs. If investors are contemplating purchasing deep-out-of-the-money options, they should be aware that the chance of such options becoming profitable ordinarily is remote.

Selling options generally entails considerably greater risk than purchasing options. Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of that amount. The seller will be liable for additional margin to maintain the position if the market moves unfavourably against him. The seller will also be exposed to the risk of the purchaser exercising the options and the seller being obligated to either settle the options in cash or to acquire or deliver the underlying interest. If the options are 'covered' by the seller holding a corresponding position in the underlying interest or a futures or other options contracts, the risk may be reduced. If the options are not covered, the risk of loss can be unlimited.

 

iii. Others 

Terms and conditions of contracts

Investors should ask their brokers about the terms and conditions of the specific futures or options contracts and associated obligations (e.g. the circumstances under which investors may become obliged to make or take delivery of the underlying asset of a futures contract and, in respect of options, expiration dates and restrictions on the time for exercise). Under certain circumstances (e.g. the issue of bonus shares by a listed company or payment of large special dividends), the specifications of outstanding contracts (including the exercise price of options) may be modified by HKEX to reflect changes in the underlying asset.

Suspension or restriction of trading

Market conditions (e.g. illiquidity) and/or the operation of the rules of certain markets may increase the risk of loss by making it difficult or impossible to effect transactions or liquidate/offset positions. If investors have sold options, this may increase the risk of loss.

 

5.6.3

What are the trading hours of the HKEX derivatives market? 

Like the securities market, trading in the Hong Kong derivatives market is conducted Monday to Friday (except public holidays). However, the trading hours (including the last trading date, the expiry date and the final settlement date) of different derivatives may vary. For details, investors may refer to the trading calendar and the contract summary of each product in “Derivatives Products” under the “Products & Services” section of the HKEX website.

 

5.6.4

What is the function of the pre-market opening session in Hong Kong’s derivatives market?

The pre-market opening session helps establish an orderly market open when the trading system is loaded with large numbers of orders and provides the market with a fair mechanism to determine the calculated opening prices (COP) at which the largest possible number of contracts may be traded, based on a predetermined formula. This helps to maintain order at the market open and minimise price fluctuation. During the pre-market opening session, the COP is established before the market open without matching orders. At present, the pre-market opening session is only available for the trading of Hang Seng Index futures, Mini-Hang Seng Index futures and H-shares Index futures.

 

5.6.5

What is Calculated Opening Price (COP)?

During the pre-market opening session, a COP will be calculated if the highest bid price of the limit orders entered into electronic trading system is greater than or equal to the lowest ask price of the limit orders, and the price will serve as the market opening price for the corresponding product. If more than one price satisfies this criterion, the COP will be calculated according to the established formula set forth in Rule 4.83 of the trading procedures for stock index futures and options under the Rules, Regulations and Procedures of the Futures Exchange. The rules are available in the “Rules and Regulations” section of the HKEX website.

 

5.6.6

What are the charges involved in futures and options trading? 

Futures and options brokerage is negotiable between brokers and their clients. All futures and options traded on HKEX's derivatives market are stamp duty free. Other charges including the Exchange Trading Fee and the SFC (Securities and Futures Commission) Levy vary from one product to another. Investors should consult their brokers and read carefully the contract specifications before trading. Details of trading fees are available in the “Derivatives Products” under the “Products & Services” section of the HKEX website.

 

5.6.7

Why is it necessary to pay margin for trading futures and selling options contracts?

The clearing houses of HKEX acts as the central counterparty to both the buyer and seller of futures and options so that the counterparty risk of both parties is limited to a single counterparty.

As the central counterparty, it is the clearing house’s statutory duty to manage the risks associated with the clearing and settlement business in order to maintain a stable and orderly clearing and settlement system for the different exchange traded financial products. To this end, HKEX use a series of risk control measures, and one of them is the margin requirement.

Clearing House Participants (i.e. brokers) are required to pay to the clearing house a Clearing House Margin in respect of their open interest (held by the Participants themselves or for their clients). Clearing House Participants in turn charge their clients an amount not less than the Client Margin. There are two types of Client Margin: Initial Margin and Maintenance Margin. The amount of margin is determined by the clearing house using a programme named Portfolio Risk Margining System of HKEX (PRiME) taking into account the historical price volatility of the underlying products (e.g. stocks, indices etc), market conditions and other relevant factors. When opening a position, an investor is required to pay an initial margin to a Clearing House Participant, which then calculates the floating profits or losses of the investor’s position each day after the market close and credits or debits the margin balance accordingly. If the initial margin deposit falls below the maintenance margin, a margin call will be issued, and the investor must deposit additional funds to restore the account to the initial margin level if he does not want to close the position.

 

5.6.8

How do investors know the futures or options margin requirements?

The margin charged by brokers may vary depending on their assessment of the financial conditions and position of a particular client, but will not be less than the minimum amount stipulated by HKEX.  HKEX prepares on a daily basis a margin reference table using historical figures. Brokers may refer to the table when assessing the client margin every trading day. The margin reference table is posted at “Derivatives Products” under the “Products & Services” section of the HKEX website. It should be noted that the margin reference table only sets out the minimum margin. The exact margin charged by brokers depends on the financial conditions of each particular client.

 

5.6.9

Is there a market making system in the Hong Kong derivatives market? What are the obligations of market makers? 

Market makers are allowed in the Hong Kong derivatives market to increase market liquidity and efficiency. Investors can check the List of Market Makers form “Derivatives Products” under the “Products & Services” section of the HKEX website. Market makers are obliged to provide bid and ask quotes for particular products. Details are set out in “Market Maker Obligations and Incentives” under “Derivatives Trading Information” of the “Market Operations” section of the HKEX website.

 

5.6.10

What is Close Out?

Futures – An investor can close out his position by buying or selling futures contracts of the same expiry date and quantity but in the opposite direction in order to offset his original position. After the position is closed out, he will no longer have any position in the same futures contracts in his account. 

Options – Where an investor makes an opposite order after buying options contracts, i.e. selling the same quantity of options contracts, his position in the options contracts will be closed out. 

 

5.6.11

What is Open Interest?

Open Interest is the total number of futures or options contracts that have been bought or sold, but not settled by offsetting transactions or fulfilled by delivery of the underlying asset. Each open transaction has a buyer and a seller, but for the calculation of open interest, only one side of the contract is counted by the clearing house.

 

5.6.12

What is Roll-over?

Roll-over involves closing out the expiring position in futures/options contracts first and opening a new position with a later expiry date but the same contract specifications. For example, an investor who has opened a short position in Hang Seng Index futures contracts which expire in September but remains bearish on the performance of the Hang Seng index in October may close out the September contracts and open a short position in Hang Seng index futures for October expiry. The move to renew a futures contract is called roll-over.

 

5.6.13

What are the orders commonly used in futures and options trading?

Orders that are more commonly used are set out below. Investors should contact their brokers to see if they provide the relevant services before placing an order.

Auction Order - An Auction Order is an order where a bid or offer price is not specified and is entered during the pre-market opening session for execution at the Calculated Opening Price (COP). Given the difference in the quantity of buy orders and sell orders during the auction session, not all auction orders may be matched. Unmatched auction orders will be converted to limit orders at COP, or the best bid or the best ask after the market opens. Where investors predict the market will go up or down at market open, they may input auction orders to buy or sell their contracts at the opening price before the market opens.

Limit Order - A limit order is an order to buy or sell at a specific price or a better price. Investors who do not feel there is an urgent need to execute a trade or who are determined to try to capture the short-term trend in price may input limit orders to try to buy or sell contracts at the price they have in mind.

Market Order - A market order is an order to buy or sell immediately at the current available price without any price restriction. For investors who feel there is an urgent need to buy or sell contracts, the quickest way to execute a trade is to input a market order.  However, investors should note that the execution price may deviate from the price they have in mind.

Stop Order - A stop order is an order to buy or sell at a specified price. Where the current market price is the same as the specified price, the stop order will be converted into a market order immediately. During futures trading, a stop order is often used to close out investors’ positions to minimise losses and manage risks. Therefore, a stop order is also known as the stop-loss order.

To increase order flexibility, additional instructions may accompany an order input. Some commonly used instructions are set out below.

Rest of Day - Orders are valid only on the trading day indicated by investors, and become invalid after the market close.

Fill or Kill - Applicable to a limit order only. Where the order cannot be matched at the exact quantity of contracts at the specified price, it will be cancelled automatically at once and will not be executed. For example, an order to buy 10 contracts will be cancelled if there are only five contracts available in the market at the moment.

Fill and Kill - Applicable to a limit order only. Its purpose is to execute as many contracts specified in the order as possible and cancel the remaining unmatched portion. For example, if an investor intends to buy 10 contracts but there are only six available in the market, six contracts will be bought, the remaining four will not be bought and the unfilled part of the order will be cancelled. 

 

5.6.14

Will investors be given any acknowledgement after trading in futures and options?

Like trading in securities, brokers issue a contract note to their clients upon the closing of a transaction or their clients will receive a daily activity statement after the market closes on the day the transaction is completed. All relevant information of the transaction and the balance of the account at the cut-off date are covered therein. In addition, a statement of account is issued by brokers on a monthly basis. Investors should check carefully the information on these statements.