David Floyd's SSF Watch, Part 2

To All TM Members: Dave Floyd is a successful daytrader who sees tremendous opportunity in SSFs. In this new four-part series, David Floyd's SSF Watch, he will explain to you the tremendous advantages of SSFs and why he is gearing himself up to trade them once they go live (and why you should too). In addition, he will teach you all the important mechanics of futures trading and most viable strategies to consider applying to SSFs.

With just over two months until the launch of Single Stock Futures (SSFs), it is time to discuss some of the mechanics and specifics surrounding these new securities. In Part 1 of my SSF Watch Series, I outlined the various reasons why I will be trading these products once they are launched. Regardless of one's level of trading experience, we will all need to bring ourselves up to speed on the following topics:

SSFs: What exactly are they?

The mechanics of SSFs: What happens when you buy and sell them? How do you make money trading them?

Margin and leverage: What kind of gains or losses can I be exposed to if I trade SSFs?

Profit and loss calculation: What exactly happens to your bottom line in the course of a trade?

SINGLE STOCK FUTURES: WHAT ARE THEY?

When an SSF transaction occurs, two parties agree to buy or sell 100 shares of a particular stock at a predetermined price on a future date. The contract represents an obligation to the buyer to buy 100 shares of stock at a predetermined price and an obligation to the seller to deliver/sell 100 shares of stock at the predetermined fixed price. Futures contracts are standardized contracts and are bought and sold on a federally regulated exchange such as the Chicago Mercantile Exchange or the Chicago Board of Trade. In the case of SSFs, they are regulated by both the Securities and Exchange Commission and the Commodity Futures Trading Commission.

You can take your pick from expirations in the first five calendar quarters (expiring in March, June, September and December) and in the first two non-quarter calendar months. The "tick" size of SSFs (minimum price fluctuation) is one cent per share, or $1 per contract.

MECHANICS OF SSFs

The mechanics of trading SSFs are similar to trading stocks Do think the price of a stock will go up? If so, then go long. Think it'll go down? Then "go short" the futures contract.

Unlike stocks, in SSFs the uptick rule does not apply, therefore there is no restriction when it comes to shorting.

For example, it's now the first week of May and after analyzing your charts, you're bullish on Home Depot (HD | Quote | Chart | News | PowerRating). Therefore, you can buy a June futures contract on Home Depot at $50. This obligates you to buy 100 shares of Home Depot at $50 upon expiration on the third Friday of June. You can cancel your obligation to buy the 100 shares of Home Depot at any time prior to expiration by simply selling the contract. You will make $100 dollars per contract for every dollar that Home Depot is above $50. Whereas, you will lose $100 for every dollar that Home Depot is below $50.

Likewise, if instead you were bearish, you can sell a June futures contract on Home Depot at $50. This, of course, will obligate you into selling 100 shares of Home Depot at $50 at expiration. To cancel this obligation, you can simply buy back the futures contract. You will make $100 per contract for every dollar that Home Depot is trading below $50. You will lose $100 per contract for every dollar if Home Depot stays above $50.

MARGIN & LEVERAGE

Futures trading involves the use of margin or a "good faith deposit." With stock, you purchase shares with cash equaling the full amount of the stock, or 50% of the amount in a margin account. In SSFs, you only need to put up 20% of the amount of the stock. For example, with Home Depot trading at $50, you need $5000 to purchase 100 shares (one round lot). With SSFs, you only need to put up $1000 ($50 X 100 X .20). Although this might seem like a benefit in which you gain a tremendous amount of leverage, you have to remember that leverage is a double-edged sword. Unlike stock where your risk is limited to the amount of the investment, with futures, you could lose more than what you put in. Let's take a look a couple of examples:

1) You buy 10 Home Depot futures contracts at a $50 trade price and sold at $55.

• Here's what happens when you go long at $50 and close the position at $55:

Initial Margin: (20% x $50) x 100 shares x 10 contracts
= $10,000

Gain on position if closed at $55: $5000
Return on margin: $5,000/$10,000=50.0% For a 10% move in the stock, you would made 50%!

2) You sell 10 contracts of Home Depot at a $50 trade price and close the short position at $55. The margin level represents 20% of the value of the contracts traded for calculating the return on initial margin in these two trades.

• Look at what happens when you go short at $50 and close the position at $55:

Initial Margin (20% x $50) x 100 shares x 10 contracts = $10,000

Loss on position if closed at $55: ($5,000)
Return on margin: ($5,000)/$10,000 = (50%) A 10% move against you caused a loss of 50%!

As you can see, managing your money with cold, hard discipline and controlling losses is essential and critical. In futures trading, not only can you lose more than your initial margin deposit, but you can lose it faster than if you buy stocks on margin. Make sure you understand the risks and have your plan of attack in place before you trade SSFs.

PROFIT & LOSS

Calculating your profits and losses is very easy. If you are long futures and you sold your contract a higher price than you bought it, you'll make money. If you sold it for less than you bought it, you'll lose money. Whereas, if you sold a futures contract at a high price and bought it back at a lower price, you make money, and if you sold a contract at a higher price and bought it back at an even high price, you lose money.

• From the example above, you bought 10 contracts of HD futures at $50 and later sold them at $55. Your profit/loss will calculated as:

Long Trade: (Sell Price - Buy Price) x 100 shares x Number of Contracts
= Profit or Loss

($55 - $50) x 100 shares x 10 = $5,000

• If you shorted 10 contracts of HD at $50 and bought them back at $55, your profit/loss would calculated as:

Short Trade: (Buy Price - Sell Paid) x (-1) x 100 shares x Number of Contracts
= Profit or Loss

($55 - $50) x (-1) x 100 shares x 10 = ($5,000)

In the above calculation, I'm not including commissions.

In the next installment I will discuss the similarities and differences of SSFs and stocks. We'll take a close look at the advantages that SSFs offer to traders who are equipped with the right knowledge, strategies, and discipline.

To learn more about Dave's outlook on SSFs, click here to read Part 3 of his four-part series.