Understanding LQ45 Futures

On February 1^st, 2016, the Indonesian Stock Exchange (IDX) with the Indonesian Clearing of Securities Underwriting or ICSU (Kliring Penjaminan Efek Indonesia, or KPEI) reactivated LQ45 Futures trading. LQ45 Futures trading had been enabled since 2001, but it was discontinued in 2009 for various reasons, and is now enabled again with some improved regulations. But the questions are what LQ45 Futures is? And how does it affect the Jakarta Composite Index (JCI)?

Before we discuss LQ45 Futures specifically, we have to know first, what is ‘futures’ in finance. Futures, also called futures contract is an agreement made by two parties in which one party will sell an asset to another a predetermined price in the future. For example, the recent price of oil is US$ 30 each barrel, and A made a contract with B to buy oil from B with the cost of US$ 30 by barrel, and the oil will be handed over (including the money) in the three months after the contract occurred. So three months later. A still has to pay US$ 30 each barrel no matter if the oil price in three months rises to US$ 33, or falls to US$ 27 each barrel.

The purpose of making futures contract is to protect the buyer or the seller from possible price swings of traded assets or commodities. So if you work for Pertamina and has a plan to buy oil in large amount, for example, six months from now. Then because we do not know oil price’s development in six months, you may come to the futures exchange to make an agreement and contract with the oil seller to buy the oil six months later, but at the predetermined and negotiated price this time.

In practice, in buying and selling futures contracts, there is a chance to speculate for traders to gain profits, even though they may not intend to buy or sell the oil, because the price of assets and commodities at future exchange is usually lower than at spot market. A spot market is the place where you buy oil in a certain time, you will receive the oil right away. For example, if you buy oil at the price of US$ 30 by barrel for a delivery three months from now. But the cost is lower than the spot market which is US$ 35 each barrel. Sometimes later, when the three-month deadline approaches, the spot oil price remains at US$ 35 each barrel, so the price of the futures exchange will rise (as it is near its delivery time), for illustration, it rises to US$ 33. Thus, you earned a profit of US$ 3 each barrel alias 10% in a short period of time.

However, if the price in the spot market drops, so the price in the futures exchange also falls, thus the trader (someone who buys a futures contract for resale) will suffer losses. Compared to investment in the stock market, the risk of loss in futures exchange is very big. Because it is different with the stock prices which in the long run will rise according to the fundamental quality of the business, the price of a commodity or anything may rise or fall to any position and anytime unpredictably, and that is why futures exchange offers an opportunity for speculation (rather than an investment). When the oil price was still at the US$100’s  a barrel two years ago, no one was daring enough to imagine that its price would sink deep below US$ 30 each barrel as it is now.

As buying and selling futures contract does not (or have) not caused cause the change in asset ownership, then in the finance world, it is included as derivative products. Other derivative instruments which bear likenesses with futures are options, swaps, and forwards, but we will not discuss them further.

Okay, then what is LQ45 Futures?

As with commodities, stocks, bonds, stock index like LQ45 Index, you can trade it the future exchanges. If you predict that LQ45 will rise in the future, you may buy ‘LQ45 contract’ at a price based on its value today, and sell it later if the price goes up. The risk is if LQ45 Index falls, then you may have to sell a futures contract in a loss position.

Based on information from BEI, you will pay Rp500 thousand for each index point. So if you buy 1 unit of LQ45 future at the price of 834 (close position of LQ45 future on this day), then you have to pay Rp417 million. But, like any other futures trading, you only need to pay capital of 4% out of Rp417 million, alias Rp17 million, because the rest is a margin fund paid by the securities.

(Notes: to view LQ45 futures position, you have to open www.idx.co.id, in the left tabs, click ‘Market Information’, then click ‘Derivatives’, and last click ‘Futures’. So far there are only two securities which take part in trading the index of future contract, with a transaction value of several billion Rupiah)

The margin reason caused LQ45 Future offers an extraordinary profit, but the risk is also insane. If the value of LQ45 Future you buy today rises 10 points to 844 in the next day (up 1.1%). Then the profit is 10 times multiplied by Rp500.000, equal to Rp5 million. Whereas the capital is only Rp17 million (the profit is 30% in a day, before margin expense). Conversely, if the futures value falls 10 points, then the capital Rp17 million you owned become Rp12 million. If the decrease is bigger, then you will lose all of your capital.

However, because trading LQ45 futures does not need big capital. Then the traders who buy LQ45 futures do not intend to gain profit. They try to protecting or hedging their own investment in the stock market and from the risk of global market swing.

And that’s because, as the name implies, LQ45 future is as if it is LQ45 index position in the future, in this case one day ahead. Then, if LQ45 future rises in a certain day, so the LQ45 index itself will also rise in the next day (though probably not). The existence of LQ45 futures gives expectation to become a new benchmark for traders. They use it to review how to predict index movement on a certain day, in this case, LQ45 index and undoubtedly JCI. Because LQ45 index’s move is 99.9% identical with JCI, I have been following them for years but I never see it when LQ45 index rises but JCI drops. Another benchmarks they often use are Dow Jones, EIDO, EEM, etc. Usually, if EIDO goes down last night, then investors think that in the morning JCI will go down as well. And if everyone thinks that JCI will go down, then it could be JCI is going down.

Now, with LQ45 futures, people's attention will not only focus on EIDO and others, but also LQ45 futures, in which, if the value goes up, then people may still be optimistic in JCI, even if EIDO closes at down position in the night.

There is also a concern that LQ45 future may even become 'a toy' for the bookmarkers, who deliberately lift or lower it effortlessly (because they only need small capital), and it may impact JCI’s movement. But I think for now the concern is unacceptable, because the value of LQ45 futures transactions is still little, only a few billion Rupiah per day (compared with the transaction value of all shares in BEI, which reached Rp6 trillion per day), so no matter what position LQ45 Future moves then it will not affect the JCI significantly. In addition, LQ45 futures contract is not just one, but there are several, and the value of each contract can vary. Trading LQ45 future still needs time, maybe at least a year, so it attracts by the traders and influences their decision in buying or selling shares.

But to test the power of LQ45 future, then you can check it by you: When I wrote this article, the closing position of LQ45 future for Thursday, February 11, is 834, or lower than the LQ45 index itself at 839. It means that traders who buy LQ45 future over the course of Thursday afternoon predict the LQ45 index may fall. Well, let's see, if the LQ45 index, and of course also JCI, will go down tomorrow?

LQ45 Future Position, you can find it in www.idx.co.id. Click the picture to enlarge it

Original article was written (in Indonesian Language) in February 12, 2016. For inquiries, please contact the author by email, teguh.idx@gmail.com.