It's been a long, hard trip for single-stock futures. Banned 20 years ago, the contracts have been at the center of a bitter regulatory turf war, shunned by competition-wary exchanges and dogged by public image problems -- all before they ever began trading. Now, with their regulation split between the Commodities Future Trading Commission and the Securities and Exchange Commission, single-stock futures are ready to debut on public markets. While nobody's betting they will be an overnight success, experts say they offer a good hedging option for traders who know what they're getting into.
Investors might assume that a single-stock future is like an option given that both deal with the price of a security some time hence. But in fact, futures act more like stocks bought on margin. For one thing, they don't carry a strike price, meaning an owner is obligated to take delivery of the underlying shares regardless of how much they cost at execution. Futures are purely directional plays: bearish if sold, bullish if bought. Furthermore, since stock futures can be, and generally are, bought and sold in secondary markets before the underlying shares are delivered, their real-time price hews to that of the underlying security. Indeed, there is one primary difference between a single-stock future and stock bought on margin: Futures require less money down and facilitate an easier bearish bet, in that one needn't borrow stock to play a decline nor wait for an uptick to go short. Simply put, the contracts guarantee delivery of shares at a designated future date. One contract is equivalent to 100 underlying shares, and the minimum margin requirement is 20%. Say an investor is looking at Microsoft, which trades for about $48. The investor is bullish and decides to buy five contracts. Because each contract is worth $4,800 ($48 times 100), five contracts has a notional value of $24,000, or five times $4,800. To place the trade, the investor must put down at least 20% of the market price, which in this case also happens to be $4,800. The contract rises $2 to $50, at which point the investor sells, pocketing $1,000. The increase is the product of $200 times five contracts, or $1,000. The downside risk of single-stock futures are identical to the risk one assumes in a margin account: specifically, that losses will exceed the original down payment. Say the investor made the same trade and Microsoft fell $20 to $28 a share. For the futures owner, that's a loss of $10,000 ($20 times 500), even though the initial margin was only $4,800. Though most investors would hear from their broker if the market tanked to that degree, the point is that, unlike stocks, the potential for swift losses is great. By the same logic, if an investor sold those five contracts and the shares fell $20, he profits $10,000. The dangers of shorting are slightly more pronounced in that an investor can be liable to deliver the physical shares underlying the stock if the contract is held to expiration.
Know What You're Doing
"Retail investors ought to educate themselves before using these products," said Marty Doyle, managing director for business development for OneChicago, one of the four exchanges that already has announced intentions to list single stock futures. The futures will be offered by OneChicago (a joint venture between the Chicago Board of Trade, the Chicago Mercantile Exchange and the Chicago Board Options Exchange) and the American Stock Exchange, Island Trading and NQLX (a joint venture of Nasdaq and the London-based LIFFE Exchange.) All but the Amex will offer the new products electronically. "We're getting the greatest early interest from hedge funds and the proprietary trading community," said Tom Ascher, chief executive officer of NQLX. Individual investors who now trade futures on stock indexes also are expected to jump in. Futures brokerages firms have been holding mock trading of single stock futures to get their customers ready.
Will Anyone Care?
But the bigger question is whether securities brokerage firms will encourage their securities customers to trade the new products. Industry statistics show retail securities accounts outnumber futures accounts by about 34 to 1. So far, securities brokerage firms aren't jumping on the single-stock futures bandwagon. "We don't have any firm plans right now to offer this product. It depends on what our customer demand is once they start trading," said a spokeswoman for Charles Schwab, one of the larger retail brokerage services. But Tom Pearson, the chief financial officer of Peregrine Financial Group, said he believes 100% of his futures customers will be interested in trading single-stock futures. "They're accustomed to the futures market," he said, noting many of them now trade futures on the S&P 500, Nasdaq 100 and Dow Jones indices. Of his securities clients, Pearson sees about 5% to 10% expressing interest, mostly from those who trade equity options: "Single-stock futures can offer customers a reasonable way to hedge a portfolio."