Single Stock Futures — The Essentials

September 28, 2001
Marc Dupee

Markets continuously evolve and a new class of financial products is just on
the horizon. Single Stock Futures (SSFs).Â

Unlike owning equities where you become part owner of a company, a single stock futures
is a derivative instrument where no ownership rights in a corporate entity are
conferred. Rather, a (SSF) derivative is a contract whose value is based on the performance of
an underlying asset, in this instance a single stock. As the name implies, a futures
contract conveys the
obligation to buy or sell the underlying stock at a contractually specified time in the
future.Â

More simply put, single stock futures are standardized futures
contracts on shares of individual companies.

If other futures contracts (S&Ps, bonds, or bellies) are any indication, most SSF
“contracts” will be “offset” (covering a buy with a sell,
and vice versa) rather than concluded through the actual delivery of the
underlying stock. Once you understand this difference; that futures are traded
in series of contract months that expire on a rotating basis; and perhaps
some idiosyncratic differences in trading practices; the experience of analyzing
and trading SSFs will be much the same as that of stocks. A stock goes up, a
stock goes down, or it goes nowhere. Your job is to figure out where it’s going and to
implement strategies that let you profit from the moves.

A Brief History

You may be wondering why SSFs have not been available until now. In fact, SSFs are available
on more than 200 companies from countries ranging from
Australia to the United Kingdom. But previously enacted legislation prevented
them from being available here in the US. And herein lies part of the problem
that has prompted the industry to push to rectify a bureaucratic snafu enacted nearly 20 years
ago. The regulations
prohibiting SSFs have put US financial markets at a competitive disadvantage, stymieing
financial innovation.

The so-called Shad-Johnson Accord was introduced in 1982 and
prevented (among other things), trading of stock futures in the US. Initially,
Shad-Johnson was implemented to deal with exchange regulatory issues. The Accord’s
intention was to review the situation soon after its
implementation. But
18 years passed andÂ overseas equity and futures exchanges innovated (grabbing a bigger piece of the financial
pie) while the US was left behind.

So Congress enacted the Commodity Futures Modernization Act of 2000 (CFMA).
The CFMA lifted the 19-year ban on the trading of single-stock and narrow-based
stock index futures in this country. Now, exchanges are scrambling to make alliances,
finalize regulatory issues, and carve out niches in the unmapped SSF territory.Â Â

While the roadmap is not complete, we have a pretty good idea of what the
terrain will like when the new the products come on line.

The EssentialsÂ

WhoÂ

At least three major entities are gearing up to make markets in single stock
futures.Â

Another prominent player is the partnership between the Chicago Board Options
Exchange (CBOT), Chicago
Mercantile Exchange (CME) and Chicago Board of Trade (CBOT). Since no official
name for the alliance has been, given, we’ll call it the Chicago Joint Venture
(JV). The three plan to
“offer futures on between
25 to 50 stocks,” said Richard DuFour, executive vice president of the
CBOE.

Similarly, the American Stock Exchange plans to offer futures on 50 to 100
stocks.Â

WhatÂ

Again, single stock futures are standardized futures
contracts on shares of individual companies.Â

While the stocks that will have SSFs traded on them in the US have not been
announced yet they will undoubtedly be contracts on the best known, most liquid
names. The more individuals and institutions know about the underlying stock,
the more likely they will be to participate in the SSFs markets.Â

The contracts will represent 100 shares of the underlying stock, with the tick size of one penny
representing $1 in value. Hence, a 50-cent move in the price of the underlying
(cash) stock would equate to a change in the contract value of a SSF of $50.
Similarly, if the underlying were to decline by $1 (100 ticks) theÂ value
of the contract would decline by $100. Futures contracts are marked-to-market
every day, meaning the values — the gains or losses –Â are realized in customers
accounts on the same day.Â

The contracts will be physically settled. This means that if you hold a long
contract until the end of the futures contract’s expiration month, you can have
the actual shares of stock delivered to you. The thought behind this is there
will be less chance for any manipulation of prices during settlement due to the
depth and liquidity of some of America’s most widely held stocks. By contrast,
LIFFE SSFs are cash settled, although the exchange denies there has been price
manipulation upon settlement.Â

In summary:

Contract size is 100 shares of the underlying

Tick size is .01 with a tick value of $1, so every $1 movement in the underlying
is worth $100.Â

Physical Delivery

Rules governing the underlying stock will be coordinated

WhenÂ Â

Trading of SSFs between institutions is currently permitted under the
CFMA. Under the CFMA, the (NQLX), the Chicago
JV, and the AMEX can begin trading SSFs for customers on December
21, 2001. But as a representative of the NQLX said, “the Friday before Christmas
is not exactly the best day to launch a product.” Regulatory issues have
not been finalized, stocks upon which SSFs will be traded have not been
announced, and a set back across the financial industry due to the attack on the
World Trade Center make it doubtful that SSFs will be available to trade before
next year.

Still, representatives from the NQLX and the Chicago JV
both maintain they are “proceeding as if we will commence trading by
December 21.” More likely will be a start before April 1, a
date that was originally recommended by futures industry leaders (Dec. 21 is the
legislated legal start date).Â

All three entities are saying they will trade SSFs between the hours of 9:30 a.m. to
4:02 p.m. ET

As mentioned above, futures are traded in a series of contract months
that expire on a rotating basis.Â There will be six contract months available for
trading; the three closest
months as well as quarterly contracts. If SSFs start trading on Dec. 21, then the
“nearby” SFF on say Microsoft will be the January 2002 contract. Contracts
would also be available for February, March, June, September, and December as
well.Â Â

Where Â

SSF contracts will trade on electronic exchanges. Delivery of the stock is
still a matter regulators are working out.Â

The NQLX has a trading platform called LIFFE CONNECT, the same system used
for the all-electronic Universal Stock Futures that LIFFE trades from London.
NQLX touts the platform as “a state-of-the-art
electronic trading system designed by LIFFE that is the world’s most
advanced derivatives trading system, offering unrivalled execution speed and
flexibility.”

The Chicago Board Options Exchange (CBOE), the Chicago Mercantile Exchange
Inc. (CME) and the Chicago Board of Trade (CBOT) plan to use CBOEdirect and
GLOBEXÂ®2, also electronic platforms that have enjoyed high levels success and
market acceptance.

Similar to the way options markets are made at the CBOE, the Chicago JV will
have Designated Primary Market Marketers (DPMs). Similar to a stock specialist,
they job is to make a two-sided market, available to buy and sell at some
price.Â

NQLX has not announced how it will assign market makers.

Why

One of the main reasons to trade SSF will be the leverage afforded by lower margins.
Margins are really performance bonds set by the exchange, a kind of a minimum
down payment that is less than the full value. Margins have been set at 20% of
the underlying stock’s value. So if you wanted to buy 100 shares of Microsoft
stock and the stock was trading at $60, it would cost you $6,000. But to buy a
SSF, it would cost you 20% of that or $1,200. I’ve heard Kevin Haggerty
something to the effect (these are not his numbers), “if you like a stock
setup at a cost of $6,000 you’ll love it $1,200.”

Of course leverage is a two-edged sword and losses can be made just as
quickly as gains.Â

But to give you an idea of the effects of leverage using our example, a $3
move in Microsoft would return $300, yielding a 5% profit on the $6,000. An $8
move in MSFT yields a 13% return on the six grand.

On a SSF, an equivalent $3 move also returns $300 per contract, but yields a
25% profit ($300/$1200), an $8 move returns an $800 profit ($800/$1200), a 66%
return.

Another benefit in futures (and SSFs) is there is no “up tick
rule.” The up tick rule prevents you from selling short a stock unless it
trades higher, unless it up ticks. This is particularly applicable in plunging
market situation, when tanking stocks may not up tick until it is several points
lower. Although extremely fast market conditions can hamper getting good fills
in futures markets, the electronic matching engines in trading platforms
generally do a good job of getting trigger-happy traders fills very close to the
market in most market conditions.Â

With short stock sales, one also needs to borrow stocks from a firm that
loans them in order to short sell them and buy them back at a later date.
Situation arise where there are no shares available to borrow and sell short or
where you are forced out of a position. Jon Najarian put it nicely in a recent
commentary after attending the Futures Industry Association conference on
SSFs.Â

“As many of you have
doubtlessly experienced, stocks such as Krispy Kreme (KKD)
that have limited floats, meaning they are virtuallyÂ Â Â Â Â Â Â Â
impossible to borrow, are
very difficult to play the downside. Donâ€™t get me wrong, a stock thatâ€™s hard
to borrow will create some tough demands on the single stock future for that
stock as well, but once you establish a short position, you wonâ€™t be forced
out like you could be if you were short the underlying stock.”

Cheaply hedging existing portfolio holdings is another essential reason
investors may wish to use SSFs. Say you anticipate
a short-term fall in a stock and you are long the stock. You can sell a futures to avoid making a loss, without having to sell the
shares. Any loss
caused by a fall in the price of the stock is offset by gains made on the short
futures position. Margins on “hedged” positions are generally much
lower than margins for speculative positions. You incur the cost of commissions
on the transaction.Â Â

With multiple contract months, advanced players will stand to benefit by
employing spreading and arbitrage strategies.Â

Why Not?

There are plusses and minus to every equation. Commissions are a concern
with SSFs. The average commission on a 1,000 block stock trade is approximately
$20 per side or $40 in and out. The average futures commission is $10 per side,
or approximately $20 for the round turn. With SSF contracts specified at 100
shares, a SSF trade equivalent to a 1,000 block stock trade will cost
$200.Â

Liquidity is another matter. Level II trading, decimalization, and SEC
regulatory changes have greatly increased competitiveness and liquidity in
equities. The futures market has been slower to respond but have become much
more efficient with electronic futures markets. Market makers have a fiduciary
responsibility to make markets, but they also function to profit. Volume will be
critical to getting narrow-spread trades and good fills, particularly for block
trades.

Single Stock Futures — The Essentials

BUY THE FEAR, SELL THE GREED

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