David Floyd’s SSF Watch, Part 3
In the
previous two installments I highlighted some of the various reasons
why I was planning on trading SSFs as well as touching upon some of the basics
of SSFs. In this third installment I will discuss the contract size as
well as a more in depth comparison between individual stocks and SSFs and
naturally the leverage that SSFs offer. In my final installment we will
roll up our sleeves and examine some of the strategies which can be employed
with SSFs. This last segment is what will win you over to seriously
considering trading SSFs.
The objective of this series has been
to familiarize traders and investors with these new securities. SSFs have not
been traded in the U.S. since the 1930s when a scandal prompted Congress to ban
the high-leverage instruments. That ban was lifted in December 2001. As many of
you may know, SSFs have been trading in Europe for some time now, with limited
success. I don’t feel this is a fair comparison to how SSFs will fare when they
are introduced here. In the U.S. the cultural view of participating in the
securities markets is far different than our friends in Europe. Our culture
seems to gravitate more towards products and services that empower oneself.
Secondly, commission structures, particularly in England, make it prohibitive
for individuals to trade short term.
Stocks vs SSFs
Like stocks, SSFs carry with them a
measure of risk and reward. The are some pretty significant differences in the
magnitude of the risk and reward and beyond that, other major differences as
well.
Let’s get into the actual act of
putting on a futures position. When you put on either a long or short position,
you need to make sure your broker has the funds in your account. Unlike what you
may be accustomed to with stocks, this is not for the purpose of paying for
stock. If you are long a futures contract, the money you put up wasn’t for the
purpose of buying it. If you are short a futures contract, the money you put up
was not for the purpose of selling it. In reality, the money you deposited was
good faith deposit that ensures that you can live up to your end of the bargain
in case the futures position moves against you. The government sets the amount
for “initial margin” but your broker has the right to ask for more
depending upon his analysis of the risk within any given position.
But aside understanding the
differences between what margin is in the world of futures vs. what it is in the
world of stocks, the other major distinction is the following:
- The Federal Reserve sets the
maximum percentage of the stock purchase on margin that can be set as a
loan, presently 50%.
- In the futures world, margin can be
a moving target changing daily as the position makes or losses money. SSFs
will have initial margin requirement of probably 20% minimum — much
greater leverage.
Margins &
Leverage
If you have traded stocks on margin,
you probably have had, at one time or another, first hand experience the risk
that’s involved. Well, risk will factor in to an even greater extent with SSFs.
As you learn about SSFs, it pays to study many examples of the dynamics of
position management as the price of the underlying stock fluctuates. Movement
that is mere “noise” to a conventional buyer of stock can feel like a
stabs wounds alternating with moment of ecstasy to a naive SSF trade who doesn’t
understand how to control risk. Let’s say you are long an SSF in ABC Company at
$50. For some reason, you decide not to use stop (never do this…always use a
stop!). You watch the stock climb to $55 and you’ve made 50%. You’re in ecstasy
and hold the position overnight. In overnight trading, foreign markets drop. On
tomorrow’s opening bell, the market opens slightly positive, but then begins to
plummet…rather slowly at first. You’re sitting there watching your gains from
the previous day erode. The market deterioration accelerates and before you know
it, you’re in the red. But you figure it’ll bounce back and you convince
yourself to hold onto the position. You pat yourself on the back for having
deposited more funds than you need, thereby preventing a margin call. But by the
final two hours…you’re sweating profusely. You bail out at 45 are you
basically down 50%. Not fun.
The best favor I can do for you is to
give you this kind of illustration because it will help you to do the right
thing. I would be doing you a disservice by merely showing you a rosy picture.
But indeed, when you apply stops with discipline and have a good strategy, you
will find that SSFs have a great deal to offer you. I will explain the upside in
my next installment of SSF Watch.
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