Single stock futures (SSFs) are contracts between two investors. The buyer promises to pay a specified price for 100 shares of a single stock at a predetermined future point. The seller promises to deliver the stock at the specified price on the specified future date. Read on to learn all about single stock futures and find out whether this investment vehicle could work for you.
Futures on individual equities have been traded in England and several other countries for some time, but in the United States, trading in these instruments was prohibited until recently. In 1982, an agreement between the chairman of the U.S. Securities and Exchange Commission (SEC), John S.R. Shad, and Philip Johnson, chairman of the Commodity Futures Trading Commission (CFTC), banned the trading of futures on individual stocks. The Shad-Johnson Accord was ratified by Congress in the same year. Although the accord was originally intended to be a temporary measure, it lasted until Dec. 21, 2000, when President Bill Clinton signed the Commodity Futures Modernization Act (CFMA) of 2000.
Under the new law, the SEC and the CFMA worked on a jurisdiction-sharing plan, and SSFs began trading in November 2002. Congress authorized the National Futures Association to act as the self-regulatory organization for the security futures markets.
Initially, SSFs began trading in two U.S. markets: OneChicago and the NQLX. In June 2003, however, Nasdaq transferred ownership of its stake in the NQLX to the London International Financial Futures and Options Exchange (LIFFE). Then, in October 2004, the NQLX consolidated its contracts with those of OneChicago, leaving that organization as the primary trading market for SSFs.
The Options Clearing Corporation or the Chicago Mercantile Exchange (owned by CME Group) clears trades in SSF contracts. Trading is fully electronic through either the Mercantile Exchange's GLOBEX® system or the Chicago Board of Options Exchange's system called CBOEdirect®.
The Single Stock Futures Contract
Each SSF contract is standardized and includes the following basic specifications:
- Contract Size: 100 shares of the underlying stock
- Expiration Cycle: Four quarterly expiration months - March, June, September and December. Additionally, two serial months are the next two months that are not quarterly expirations.
- Tick Size: 1 cent X 100 shares = $1
- Trading Hours: 8:15 a.m. to 3 p.m. CST (on business days)
- Last Trading Day: Third Friday of the expiration month
- Margin Requirement: Generally 20% of the stock's cash value
The contract terms call for stock delivery by the seller at a specified future time. However, most contracts are not held to expiration. The contracts are standardized, making them highly liquid. To get out of an open long (buying) position, the investor simply takes an offsetting short position (sells). Conversely, if an investor has sold (short) a contract and wishes to close it out, he or she buys (goes long) the offsetting contract.
Trading Basics - Margin
When an investor has a long margin account in stock, he or she is borrowing part of the money to buy stock, using the stock as collateral.
In an SSF contract, the margin deposit is more of a good faith deposit, which the brokerage firm holds toward the contract settlement. The margin requirement in an SSF applies to both buyers and sellers.
The 20% requirement represents both the initial and maintenance requirement. In an SSF contract, the buyer (long) has not borrowed money and pays no interest. At the same time, the seller (short) has not borrowed stock. The margin requirement for both is the same. The 20% is a federally mandated percentage, but the individual brokerage house can require additional funds.
The margin requirement for SSFs is continuous. Every business day, the broker will calculate the margin requirement for each position. The investor will be required to post additional margin funds if the account does not meet the minimum margin requirement.
Example - Single Stock Future Margin Requirements In an SSF contract on stock X priced at $40, both the buyer and seller have a margin requirement of 20% or $800. If stock X goes up to $42, the long contract account is credited with $200 ($42-$40 = $2 X 100 = $200), and the seller's account is debited by the same $200. This indicates that investors in SSFs must be very vigilant - they must keep close track of market movements. Furthermore, the exact margin and maintenance requirements of an investor's brokerage firm are key issues that must be considered in determining the suitability of SSF investments.
Speculation - Trading Single Stock Future Contracts
Note: For simplicity we'll be using one contract and the basic 20%. Commissions and transaction fees are not taken into account.
Example - Going Long an SSF Contract Suppose an investor is bullish on stock Y and goes long one September SSF contract on stock Y at $30. At some point in the near future, stock Y is trading at $36. At that point, the investor sells the contract at $36 to offset the open long position and makes a $600 gross profit on the position.
This example seems simple, but let's examine the trades closely. The investor's initial margin requirement was only $600 ($30 x 100 = $3,000 x 20% = $600). This investor had a 100% return on the margin deposit. This dramatically illustrates the leverage power of trading SSFs. Of course, had the market moved in the opposite direction, the investor easily could have experienced losses exceeding the margin deposit.
Example - Going Short an SSF Contract An investor is bearish on stock Z for the near future and goes short an August SSF contract on stock Z at $60. Stock Z performs as the investor had guessed and drops to $50 in July. The investor offsets the short position by buying an August SSF at $50. This represents a gross profit of $10 per share or a total of $1,000.
Again, let's examine the return the investor had on the initial deposit. The initial margin requirement was $1,200 ($60 x 100 = $6,000 x 20% = $1,200) and the gross profit was $1,000. The return on the investor's deposit was 83.33% - a terrific return on a short-term investment.
Hedging - Protecting Stock Positions
An overview of SSFs would not be complete without mentioning the use of these contracts to hedge a stock position.
To hedge, the investor takes an SSF position exactly opposite to the stock position. That way, any losses on the stock position will be offset by gains on the SSF position. However, this is only a temporary solution because the SSF will expire.
Example - Using Single Stock Futures as a Hedge Consider an investor who has bought 100 shares of stock N at $30. In July, the stock is trading at $35. The investor is happy with the unrealized gain of $5 per share but is concerned that the gain could be wiped out in one bad day. The investor wishes to keep the stock at least until September, however, because of an upcoming dividend payment. To hedge, the investor sells a $35 September SSF contract. Whether the stock rises or declines, the investor has locked in the $5-per-share gain. In August, the investor sells the stock at the market price and buys back the SSF contract.
Consider Figure 1:
|September Price||Value of 100 Shares||Gain or Loss on SSF||Net Value|
Figure 1 - Tracking the Gains/Losses on Single Stock Futures
Until the SSF expires in September, the investor will have a net value of the hedged position of $3,500. The negative side of this is that if the stock dramatically increases, the investor is still locked in at $35 per share.
The Major Advantages Over Stock Trading
Compared to directly trading stocks, SSFs provide several major advantages:
- Leverage: Compared to buying stock on margin, investing in SSFs is less costly. An investor can use leverage to control more stock with a smaller cash outlay.
- Ease of Shorting: Taking a short position in SSFs is simpler, less costly and may be executed at any time - there is no requirement for an uptick.
- Flexibility: SSF investors can use the instruments to speculate, hedge, spread or use in a large array of sophisticated strategies.
Single stock futuress also have disadvantages. These include:
- Risk: An investor who is long in a stock can only lose what he or she has invested. In an SSF contract, there is the risk of losing significantly more than the initial investment (margin deposit).
- No Stockholder Privileges: The SSF owner has no voting rights and no rights to dividends.
- Required Vigilance: SSFs are investments that require investors to monitor their positions more closely than many would like to do. Because SSF accounts are marked to the market every business day, there is the possibility that the brokerage firm might issue a margin call, requiring the investor to decide whether to quickly deposit additional funds or liquidate the position.
Comparison with Equity Options
Investing in SSFs differs from investing in equity options contracts in several ways:
- Long Options Position: The investor has the right but not the obligation to purchase or deliver stock. In a long SSF position, the investor is obligated to deliver the stock.
- Movement of the Market: Options traders use a mathematical factor, the delta, that measures the relationship between the options premium and the underlying stock price. At times, an options contract's value may fluctuate independently of the stock price. By contrast, the SSF contract will much more closely follow the underlying stock's movement.
- The Price of Investing: When an options investor takes a long position, he or she pays a premium for the contract. The premium is often called a wasting asset. At expiration, unless the options contract is in the money, the contract is worthless and the investor has lost the entire premium. Single stock futures contracts require an initial margin deposit and a specific cash maintenance level.
The Bottom Line
Investing in single stock futures offers flexibility, leverage and the possibility of innovative strategies for investors. However, potential investors in SSFs should carefully examine the risk/reward profile these instruments offer and be certain that they are suitable for their personal objectives.