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Investment 101 – A Comprehensive Guide to Understanding Daily Leverage Certificates (DLCs)

A Comprehensive Guide to Understanding Daily Leverage Certificates (DLCs)

If you’re contemplating trading daily leverage certificates, it’s imperative to understand how they work, what they offer, and the risks involved. Here’s a detailed overview:

Key Insights:

  • Short-term Trading: DLCs are primarily designed for short-term trades, specifically those that settle within a single day. They might not be an appropriate choice for long-term investment.
  • Potential for Significant Returns and Losses: The leverage in DLCs can lead to outsized gains but also substantial losses.
  • Special Requirements: Since DLCs are classified as Specified Investment Products (SIP), you may have to undergo a Customer Account Review to trade them.

Understanding DLCs

Daily leverage certificates are a type of high-risk financial product. They offer investors a leveraged return anchored to the daily performance of a particular underlying reference instrument, such as a securities index like the Straits Times Index (STI).

This leverage tends to magnify the reference instrument’s movement, leading to potentially large returns or losses. DLCs can be either “long” or “short,” allowing you to speculate on both upward and downward trends.

Before diving into DLCs, familiarize yourself with specific features like the Daily Reset, Airbag, and the effects of compounding. To trade in DLCs, investors must be qualified for SIPs.

How DLCs Work

DLCs are primarily a tool for short-term trading and may not be well-suited for long-term holding. They provide traders a leveraged return ranging from 3 to 7 times the daily performance of the underlying reference instrument.

For instance, if the STI changes by 1% from its closing price the previous day, a 3x STI DLC will shift by 3%, and a 5x STI DLC by 5%. This leverage leads to amplified profits and losses, though the maximum loss is restricted to the principal amount invested.

In addition to the obvious price risks, trading DLCs exposes you to other dangers, such as the issuer’s default risk. Even a rise in the reference instrument’s value won’t prevent a loss if the issuer defaults.

DLCs offer a unique trading opportunity with the potential for significant gains, but they come with a corresponding risk level. Ensure that you’re aware of the particular features and potential pitfalls of DLCs before engaging in this form of trading.

Is Trading DLCs Right for You?

Remember, one of the most important question to ask yourself is, “How Much Could You Stand to Lose?”

Your losses in trading DLCs won’t exceed the original sum you invested.

DLCs are engineered primarily for those engaging in short-term trades. They might catch your eye if you’re aiming for the opportunity to capitalize on leveraged returns tied to daily fluctuations in reference instruments, such as benchmark indices. Should you intend to retain your investment for more than a single day, it’s vital to recognize that profits and losses can accumulate, with associated costs and fees.

Only entertain the thought of trading DLCs if you possess an exceptionally high appetite for risk and are fully prepared for the possibility of parting with your entire capital investment.

Given their speculative nature and focus on short-term trades, it’s wise to remember that DLCs may not align with the goals of a long-term investment strategy.

Understanding the Returns from DLCs

The calculation of returns from Daily Leverage Certificates (DLCs) can be intricate. Several specific aspects affect these returns:

Leverage Aspect

The leverage component heightens both returns and losses. DLCs deliver a predetermined leveraged return, ranging from 3 to 7 times the daily outcome of the core reference instrument, whether the market is ascending or descending. Consider, for example, a 1% shift in the STI from its prior day’s closing rate; this would lead to a corresponding 3% alteration in a 3x STI DLC.

Daily Reset Characteristic

A daily reset adjusts the DLC’s price at the commencement of every trading day, relying on its reference instrument’s closure the preceding day. Should you retain the DLC beyond a day, it may not accurately mirror the performance of the underlying asset, due to the effects of compounding and resets on its value.

Air Bag Mechanism

Activated if the reference index shifts against the DLC’s direction, this function mitigates losses during drastic market variations. It operates as follows:

  • Each DLC has a defined air bag trigger, such as a 10% fall for a 5x DLC or a 20% fall for a 3x DLC on a securities index.
  • Upon activation, DLC trading halts for a minimum of 30 minutes, during which the reference instrument resets to a Minimum Observed Level (MOL).
  • This new base level then recalibrates the DLC, reducing the impact of reference instrument fluctuations.

Limitations of the Air Bag

This feature might be counterproductive if the reference instrument’s value swiftly recovers after activation. It locks in preceding losses, applying subsequent gains to the MOL rather than the rebound level. Also, if the leveraged motion of the reference instrument outstrips the DLC’s value, this won’t prevent a total loss. For instance, a 5x DLC might be rendered valueless by a sharp 20% or greater decline in its reference index within a day or due to overnight shifts.

Daily Premium Attribute

A daily premium is subtracted from the DLC at each trading day’s conclusion, serving as the issuer’s hedge against overnight extreme fluctuations in the reference index. This ensures that although your entire investment could be lost, your losses won’t exceed that amount – a common concern with many leveraged products. If you liquidate your position before the trading day’s end, the premium won’t be applied.

Identifying the Risks in DLCs

Understanding the risks involved in trading Daily Leverage Certificates (DLCs) is essential for informed decision-making. Here’s an overview of the primary risks:

  1. Counterparty Risk:
  • Issuer Default: Should the issuer face default, the investment could be partially or entirely lost.
  • Foreign Entity Issues: If the issuer is located overseas, any legal recourse may be subject to foreign laws and jurisdictions, complicating the recovery process.
  1. Market and Credit Risk:
  • Underlying Instrument Factors: The underlying reference instrument’s level, volatility, liquidity, and the issuer’s creditworthiness can contribute to risk.
  • Total Loss Scenario: If the reference instrument’s decline leads to a cash settlement amount of zero or less, the entire investment could be forfeited.
  1. Liquidity Risk:
  • Limited Secondary Market: The lack of a robust secondary market might hinder your ability to purchase or sell a DLC at the desired time, potentially trapping your investment.
  1. Exchange Rate Risks:
  • Currency Fluctuations: If the DLC is traded in Singapore dollars, but its reference instrument is in a foreign currency, exchange rate changes could impact returns.
  1. Leverage Risks:
  • Multiplication of Losses: The leveraged nature of DLCs means that losses are amplified, potentially resulting in greater losses than direct investment in the underlying asset.
  1. Compound Return Considerations:
  • Deviation from Leveraged Performance: If held for over a day, the compounding effect may cause significant deviations from the expected leveraged returns, especially in volatile sideways-trending markets.
  1. Air Bag Mechanism Limitations:
  • Reduced Recoupment Ability: The activation of the air bag limits exposure to the underlying instrument, possibly constraining gains or losses relative to underlying movements.
  • Ineffectiveness in Preventing Total Loss: The air bag may not halt a complete loss in cases such as:
    • An abrupt overnight decrease (for a long DLC) or increase (for a short DLC) where the difference between closing and opening levels of the underlying instrument is 20% or more for a 5x DLC.
    • A sharp intraday change in the underlying instrument’s value during the observation period.

These complexities highlight the need for careful consideration and a solid understanding of DLCs before engaging in this type of investment.

Understanding the Role of Market-Makers and Key Features of DLCs

Market-Makers in DLCs

Market-makers are crucial in the DLC market, offering both bid and ask prices. However, there are situations when quotations might not be provided, including:

  • Pre-Market and Opening Phase: During the first 5 minutes after the opening of the SGX or pre-market opening.
  • Valueless DLCs: When the DLCs are worth less than the minimum bid size, only the offer price is provided.
  • Underlying Reference Index Issues: If trading related to the underlying index is suspended or materially limited.
  • Trading Suspensions and Closures: When DLCs are suspended or the underlying market is closed.
  • Technical Problems: This includes disruptions or technical difficulties faced by the Issuer or the Designated Market Maker (DMM).
  • Hedging Challenges: If the Issuer cannot hedge or unwind a hedge due to current market conditions.
  • Unavailability of DLCs: If the Issuer has no DLCs to sell, only the bid price is provided.
  • Exceptional Market Conditions: Such as unusual price movements and volatility.
  • SGX Market Hours Restrictions: While DLCs trade during SGX market hours (9:00 am to 5:00 pm), quotations won’t be provided if the underlying market is closed.

Additional Aspects of DLCs

DLCs also have some other specific features to be aware of:

  • Limited Lifespan: DLCs have a restricted life, typically with a maximum tenure of 3 years.
  • Delisting Protocols: DLCs are delisted upon maturity or if they lose all value due to drastic market changes.
  • Adjustments for Corporate Actions: When a DLC’s underlying reference is a corporate share, and that corporation takes a specific action (like a bonus issue), the DLC issuer might adjust the DLC accordingly. This is to evaluate whether the action has a dilutive or concentrative effect on the value of the underlying shares, and to maintain the economic equivalent value of the DLC. The issuer then sets the effective date for that adjustment.

By recognizing the role of market-makers and these particular features, investors can better navigate the complexities of trading in DLCs, aligning strategies with both market conditions and individual investment goals.

Costs, Fees, and Trading Requirements for DLCs

When considering investing in Daily Leverage Certificates (DLCs), it’s essential to understand the associated costs, fees, and prerequisites for trading. These factors can significantly impact your investment decisions and outcomes.

1. Brokerage and Spread:

  • Brokerage Commission and SGX Trading Fee: When buying or selling DLCs, you’ll incur brokerage commissions and Singapore Exchange (SGX) trading fees. These are paid to your broker.
  • Bid & Ask Spread: This refers to the difference between the price at which you can buy a DLC (ask) and the price at which you can sell (bid). It’s an essential aspect to consider in trading.

2. Management Fee:

  • If you maintain your DLC position overnight, you’ll incur a daily management fee. Check the daily rates with the product issuer to stay informed.

3. Premium for Hedging:

  • A premium is charged for hedging against drastic overnight market movements. This helps to cap your risk, ensuring you won’t lose more than your investment. The premium isn’t payable if you complete your buy and sell orders within a single day.

4. Funding and Rebalancing Costs:

  • Holding a DLC overnight leads to funding and rebalancing costs, reducing its value. These costs are particularly crucial if you plan to hold the investment for multiple days, as they may compound gains and losses. Detailed information on these expenses can be found in the issuer’s documents.

5. Trading Prerequisite in Singapore:

To trade DLCs in Singapore, you must qualify as a Specified Investment Product (SIP) trader. This qualification helps to ensure that investors have the necessary knowledge and expertise to understand the complexities and risks of DLCs.

Understanding Specified Investment Products (SIPs)

Investing in DLCs comes with various fees and requires specific considerations. Thoroughly understanding these factors and aligning them with your financial goals and risk tolerance will be key to successful DLC trading.

Make sure to consult the relevant documents, issuer’s website, or your financial advisor to have a comprehensive understanding of these costs and qualifications.

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