Talking About a Revolution

The mark of any great idea is that moment when you look at it, slap your forehead and wonder why you never thought of it. Such is the case with single-stock futures, or SSFs.

A product has to sell itself. Sponsoring giant cocktail parties at industry gatherings may generate goodwill for an evening, but will they trade your contracts tomorrow? Think of your life's epiphanies, such as learning how to ride a bike or drive a car. Someone helped you get started, but no further marketing was necessary.

SSFs are going to fit into this category. They're new in the U.S. -- look for a March 2002 launch -- and they're a little bit different. Although they've been trading in other countries for some time, the Commodity Futures Modernization Act of 2000 lifted the U.S. ban on SSFs and opened the door to them in American markets.

Yes, they're joined at the hip to those common stocks we know and love, but they're still futures contracts. Futures traders need to adjust to forward delivery, different concepts of margin, different tax and regulatory regimes, different market structures and so on.

But you'll adjust. You'll quickly shed such quaint notions as futures markets predict the future, that futures are riskier than their underlying asset, that evil speculators run the show and that the real use of SSFs will be for garden-variety hedging. (I've been in this business for 20 years, and when I meet a true hedger, I'll let you know.)

Futures traders will have fewer adjustments to make than stock traders. They're equally comfortable going short on markets as they are going long. As a result, they'll be amazed at the abuses that stock traders have endured at the hands of market and regulatory structures that practically demand a "Mother, may I?" before trading the short side. To a futures trader, the stock market is asymmetric and therefore incomplete. That's going to change.

Who Wants to Save Money?

This is a trick question. We'll all say we want to save a few bucks, but then turn around and pay more just out of habit. Let's look at the present awkward construct for going short.

First, you have to borrow the stock. You pay a healthy premium for doing so. The so-called broker loan rate, much like a credit card rate, carries a very healthy premium to other short-term interest rates. Ka-ching!

What if no one will lend you the stock or if all the stock available for lending has been lent already? The dreaded short squeeze then arises; prices can surge limitlessly higher as those who have borrowed the stock and are trying desperately to buy it back find that no one else really cares. Short squeezes are common in new issues with a relatively small number of shares outstanding or in thinly traded issues undergoing enthusiastic promotion by an, ahem, small coterie of committed salespeople.

With SSFs, all you'd have to do is sell a future. The supply of futures -- its open interest -- can expand indefinitely, and you cannot be squeezed. This obligates you to deliver the stock at expiration, but you can offset this obligation by buying the future back. They'll settle at the same price as the stock on the last trading day. You can roll your short position forward into another delivery month if you wish.

You'll also save money while having an easier time getting the short position you wanted. How? In the absence of a special situation related to a short squeeze, an SSF would trade at a basis over the stock equal to the repo rate minus the future value of the expected dividend. That means you'll earn money on your short sale at the rate of the repo minus dividend. The short-seller of a stock will pay the broker loan rate and any dividends due.

But the seller will receive the proceeds of the short sale, and these funds can earn interest. If we net all of these out, we see that a real advantage for selling short via SSFs would have existed over most of recent history. The recent collapse of the repo rate in the aftermath of the Fed's aggressive rate cuts has shifted -- temporarily, no doubt -- the advantage back to the short sale of stock.

Net Interest Rate Advantage Single-stock futures vs. stock loan

Source: Howard Simons, Bloomberg data

We can perform a similar analysis for the SSF's advantage to the buyer. A long SSF position is paying the broker repo rate and receiving the dividend. A stock buyer facing the 50% margin of Regulation T (proposed margins for SSFs are 20% of the value of the underlying stock) will be borrowing at broker loan over this portion; the margin deposit can be in interest-bearing securities.

Net Interest Rate Advantage Single-stock futures vs. 50% Reg T purchase

Source: Howard Simons, Bloomberg data

With all these advantages, who stands to lose? The only real losers will be the stock loan departments of major broker/dealers; their loss will be the gain of those traders now free to short stocks without first having to borrow them.

You Ain't Seen Nothing Yet

Once stock traders get liberated on the short side, a world of possibilities opens up for various trading strategies. For instance, take the matched pair spread. A matched pair is simply two stocks in the same industry. Over time, one tends to acquire competitive advantages over the other, and as a result, the spread between them forms a definite trend. A good example of this over the past decade has been the relationship between Coca-Cola (KO) and PepsiCo (PEP).

Coca-Cola and PepsiCo Can you spot the trend?

Source: Bloomberg

As Milton Friedman once said, one person and the truth is a majority. This product will revolutionize financial markets. You'll slap your forehead and wonder why you didn't think of it first.

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