HONG KONG—As global financial markets try to gauge the impact of a weaker yuan, China’s stock-index futures are signaling that investors are more pessimistic than current Shanghai share prices suggest.
Textbook financial theory says a currency devaluation such as the one China’s central bank engineered this week should support stocks by making them cheaper for foreign investors and lifting business prospects for local exporters. The Shanghai Composite Index has remained relatively flat since the yuan began sliding Tuesday. Stock stability in China should please regulators after their summertime battle to prop up shares.
Yet, the level of futures that trade based on Chinese share indexes tell a more negative story about investor expectations for Chinese stocks. CSI 300 Index Futures, which track an index of the 300 largest companies listed on the Shanghai and Shenzhen stock exchanges, continue to point lower.
On Thursday, the CSI 300 futures contract that trades on the China Financial Futures Exchange in Shanghai and is due to expire on Aug. 21 traded at a 1.5% discount to the actual index, while the contract due to expire in late September stood at a nearly 3% discount. A discount is a strong indicator that investors are bearish, traders say.
And since China’s efforts to prop up its share market since June have featured crimps on trading index futures, some in the market believe levels would be even weaker if the market were less controlled.
“With the crackdown, it’s hard for those that were speculating with stock-index futures to continue to,” says Bill Guo, co-founder of Cougar Asset Management Co., a Shanghai-based firm that uses quantitative trading strategies.
Chinese financial-market regulators have never been comfortable about allowing investors to profit from bad news. That philosophy has been in evidence this week following devaluation of the yuan by China’s central bank, which said the move was part of a strategy to make the exchange rate more market-oriented even though the monetary authority also appears to have worked behind the scenes to keep its currency from falling too fast.
Likewise, China’s regulatory hand is also affecting trading in stock-index futures.
As part of Beijing’s strategy to support its stock market since early July, regulators have taken steps to discourage selling pressure and limit the ability of investors to bet against the market with short sales, including by selling stock-index futures. For example, Chinese police and the China Securities Regulatory Commission said in July they were investigating “malicious” short selling, a warning that some efforts to profit from a falling market could be considered illegal.
Futures on a stock index allow investors to bet on levels of an index at a future date.
The Chinese regulatory drive against short selling comes months after CSI 300 Index Futures emerged as the world’s most actively traded stock-index futures product, topping activity in futures on the U.S.’s S&P 500 index. A boom in Chinese stock trading that took hold late last year fueled activity in futures as more professional investors joined the rally and also executed relatively complex strategies that included futures.
So far this year, CSI 300 futures have retained their crown as the most widely traded stock-index futures globally. But average daily volumes this month have slumped more than 40% from a peak of 3.2 million contracts on June 29.
As the stock market began to slump in late June, Chinese authorities said they were carefully monitoring short selling, a strategy that allows investors to make money if stocks fall. As share selling continued into early July, traders say that regulators began closely monitoring investor positions on stock-index futures and appeared to focus on investors who could be using futures purely to make money on the chance the market would fall, rather than those who had structured trades to hedge against a market fall.
Around that time, the financial futures exchange in Shanghai froze some futures trading accounts, according to one trader, sending a signal to investors that it was monitoring trades closely. “The latest regulations restrict vicious speculation, which reduces volumes,” he said.
The exchange didn’t respond to questions.
Later last month, the financial futures exchange, which lists three domestic stock-futures contracts, capped the number of orders that an investor in stock futures could input then withdraw, a move that traders said makes it riskier for them to use the products because they need to hold positions longer. In its directive, the exchange said that canceling more than 400 orders for a single contract or more than five trades a day would be considered “irregular trading,” sending a signal to investors to avoid trading in a way that might be viewed suspiciously by regulators.
And early this month, the exchange said it would limit daily activity in a lesser-traded futures product, one based on the CSI 500 stock index. In a statement announcing its strengthened oversight, the exchange said it was responding to recent “drastic market volatility, in order to curb excessive trading” and that it reserved the right to restrict trading and report suspected illegal behavior to securities regulators for possible punishment.
“In the heart of some Chinese regulators, financial derivatives are still considered evil,” said a trader at a Shanghai brokerage that specializes in futures.
The regulatory action has appeared to subdue trading volumes in futures. It was a different story when the rally was taking hold: Volume in the Chinese index futures for the first time last December narrowly surpassed activity in index futures based on the S&P 500 index, with 45.5 million CSI futures contracts trading against 40.7 million on the S&P index.
The rise of futures was then considered promising for China’s financial-market development in that it made it possible for professional traders to use relatively complex strategies involving quantitative analysis and high frequency trading. Investors can also constantly rethink their market positions by buying and selling stock futures throughout a trading session, unlike in the stock market where investors are required to hold a share position for a full day.
While it is difficult to estimate how much of that kind of trading takes place in China, Shanghai consultancy Z-Ben Advisors figures nearly 9,000 private Chinese funds were managing roughly 1.3 trillion yuan by mid-2015 and that 4% of that was dedicated to complex quantitative and mathematical stock-picking models, up from virtually zero three years ago.
“Some people have made big profits,” says Cougar Asset’s Mr. Guo.
When Chinese shares suddenly headed south in late June and many stocks fell by the 10% maximum for a single session, stock futures also pointed lower. When the Shanghai shares bottomed on July 8, the most actively traded CSI 300 futures traded at a discount of as much as 6.9% from the corresponding index. Futures levels have continued to hang beneath the actual index, resulting in the longest stretch of discount for the market since CSI 300 Index futures began trading in 2010.
The futures market discounts indicate China’s equity market is fractured, says one foreign fund manager. It reflects a desire to sell, he said, but “investors can’t sell stocks because it’s considered not patriotic.”
—Yifan Xie contributed to this article.
Write to Chao Deng at Chao.Deng@wsj.com