Understanding daily leverage certificates

Daily leverage certificates (DLCs) are high-risk financial products that give investors a leveraged return based on the daily performance of an underlying reference instrument (e.g., a securities index like the Straits Times Index).

The leverage amplifies the movement of the reference instrument, thus giving you outsized returns – and losses. DLCs may be either "long" or "short", and allow you to bet on both the rises and falls of the reference instrument.

Be familiar with the features of DLCs before trading, such as the Daily Reset feature, Air bag feature, and impact of compounding. All investors need to be qualified to trade in Specified Investment Products (SIP) to trade in DLCs.

How DLCs work

DLCs are meant for short-term trades, particularly those to be settled within 1 day. They may not be suitable as long-term investments.

DLCs give traders a leveraged return of 3 to 7 times the daily performance of an underlying reference instrument. So if the STI moves by 1% from its closing price the previous day, the value of the 3x STI DLC will move by 3%, and if it is a 5x STI DLC, the value will move by 5%.

This means that profits and losses are both amplified although the maximum loss for an investor is limited to the principal amount invested.

Other than price risks, you will be exposed to myriad risks including the default risk of the issuer. Even if the reference instrument rises in value, you will lose money if the issuer defaults.

What's the most you can lose?

The maximum loss for an investor is limited to the principal amount invested.

DLCs are primarily for short-term traders. DLCs may appear attractive if you are looking for the potential to make leveraged returns from the daily movement of reference instruments such as benchmark indices. If you plan to hold the investment for more than a day, note that gains and losses will be compounded and costs and fees will apply.

You should only consider trading DLCs if you have a very high tolerance for risk and are willing to run the risk of losing of all the capital invested.

As DLCs are for speculative and short-term trades, they may not be suitable as long-term investments.

Returns from DLCs

Calculating your returns can be complex. These features of a DLC will impact the returns, namely:   

Leverage

Leverage amplifies the returns and losses. DLCs offer a fixed leveraged return of 3 to 7 times of the daily performance of the underlying reference instrument, be it a rising or falling market.

For example, if the STI moves by 1% from its closing price the previous day, the value of the 3xSTI DLC by move by 3%.

Daily reset feature

The price of a DLC will be reset at the start of each trading day, based on the closing level of its reference instrument the day before.

If you hold the product for more than one day, DLC will not reflect the performance of the underlying reference instrument as compounding and resets may affect the value of the DLC.

Air bag feature

This mechanism will only be triggered if the underlying reference index moves against the direction of the product. It acts to reduce the amount of loss in the value of a DLC during extreme market conditions. Here is how the air bag works:

Each DLC will have a pre-set trigger for its air bag. For example:

• For a 5x DLC on a securities index, the air bag should trigger when its underlying reference index falls by 10%

• For a 3x DLC on a securities index, the air bag should trigger when its underlying reference index falls by 20% (based on the closing price of the unferlying reference index in the previous trading day).

When the air bag is triggered:

• Trading of the DLC will be suspended for at least 30 minutes

• During this time, the underlying reference instrument will be re-set to a minimum observed level (MOL)

• The MOL will then form the new base level

By re-valuing the DLC at the new base level, the movements in the underlying reference instrument will have a disproportionately smaller effect on the value of the DLC.

Limitations of the air bag

The air bag can work against you if the underlying reference instrument quickly rebounds in value after it is triggered. It will lock in the loss sustained prior to the suspension of the DLC's trading, and subsequent gains will then be applied to the MOL instead of the level that the underlying reference instrument has rebounded to.

The air bag will not prevent you from losing your entire investment where the leveraged movement of the underlying reference instrument exceeds the value of the DLC.

For example, a 5x DLC on a securities index (with an air bag that is set to trigfger if the underlying reference index falls by 10%) will become worthless if its underlying reference index suffers a sharp fall of 20% or more in the course of a trading day, or at opening of a trading day due to overnight movements.

Daily premium feature

A premium is deducted from the DLC at the close of trading each day. The premium is used by the issuer to hedge against extremem movements in the undrelying reference index that take place overnight.

This means that while you can lose your entire investment, you will not lose any more than that (which is a concern for many leveraged products).

You do not pay the premium if you close your position prior to the end of the trading day.

What are the risks?

Note that the air bag mechanism has the following risks:

May reduce the ability for the product to recoup losses – When triggered, the air bag reduces your exposure to the underlying instrument. Your gains or losses could be restricted in relation to the movement of the underlying instrument.

May not prevent total loss of investment – The air bag will not prevent you from losing the entire value of your investment, in any event of:

• An extreme overnight fall (for a long DLC) or rise (for a short DLC) in the underlying reference instrument, where the difference between the previous day’s closing level and the next day’s opening level of the underlying instrument is 20% or greater for a 5x DLC on a securities index (100%/leverage factor). This is because the air bag will only be triggered after the market opens the next day

• A sharp intraday fall (for a long DLC) or rise (for a short DLC) in the underlying instrument of the same percentage or greater during the observation period.

Role of market-makers

There will be market makers to provide bid and ask prices. However, there are circumstances where the market maker may not provide quotations. These include:

• During the pre-market opening and 5 minutes following the opening of the SGX on any trading day

• If the DLCs are valueless (where the Issuer’s bid price is below the minimum bid size) the market maker will not provide the bid price, but only provide the offer price

• Where the reference instrument is a securities index, when trading in the shares or securities relating to the underlying reference index is suspended or limited in a material way

• Where the DLCs are suspended from trading

• When the underlying market for the respective DLC is closed

• Market disruption events

• Where the Issuer or the DMM faces technical problems affecting the ability of the DMM to provide bids and offer quotations

• Where the Issuer is unable to hedge or unwind a hedge, because of prevailing market conditionsIn cases where the Issuer has no DLCs to sell, the market maker will only provide the bid price.

• If the stock market experiences exceptional price movement and volatility.

• DLCs will be open for trading during SGX market trading hours (9.00am to 5.00pm). However the designated market maker would not quote in the market if the underlying market of the respective DLCs is closed

Things to note

Other features of DLCs include the following:

Limited lifespan – DLCs have a limited life with a maximum tenure of three years.

Delisting – A DLC will be delisted upon maturity, or upon the issuer's request because the DLC has lost all its value due to extreme market movements.

Adjustments for corporate actions on underlying securities – If the underlying reference instrument of a DLC is a share of a corporation, the DLC issuer may make adjustments to the DLC if the issuer of the underlying shares undertakes a corporate action (such as a bonus issue).

If so, the DLC issuer will determine whether the corporate action has a dilutive or concentrative effect on the value of the underlying shares, It will then adjust the leveraged return of the underlying shares to preserve the economic equivalent value of the DLC and determine the effective date of that adjustment.

Costs and fees

Note that DLCs have fees and charges you need to factor in, including:

Brokerage and spread – If you trade in and out of a DLC, you will pay a brokerage commission and SGX trading fee to your broker, as well as the Bid & Ask spread.

Management fee – If you hold your position overnight, you will be charged the management fee. This is charged daily. Check the relevant daily rates on the product issuer’s website.

Premium – A premium payable for the hedging cost. The hedge is to limit your risk from extreme market movements overnight and ensures that you cannot lose more than what you have invested. If you buy and sell the DLC within the same day, you do not need to pay the premium.

Funding cost and rebalancing cost – These costs are charged to the DLC overnight and reduce the value of the DLC each time you hold the DLC overnight. More information on these costs can be found in the issuer‘s listing documents. If the investment for more than a day, note that gains and losses will be compounded and costs and fees will apply.