A Second Look at Single-Stock Futures

If you've never heard of single-stock futures, or SSFs, don't worry -- you're not alone. Part of the relatively new world of securities futures, which includes contracts on individual stocks, exchange-traded funds and narrow-based indices, these issues are now nearly 2 years old but still are having trouble gaining a foothold among mainstream investors.

While current volume and open-interest figures are admittedly uninspiring, they still showed a 60% year-over-year volume growth and are on a trajectory that is ahead of similar historical points of oil futures, euro/dollar trading and bond futures, all of which went on to become some of the most popular and successful trading products that exist. I think many people are prematurely dismissing the potential of single-stock futures in terms of growth, application and their ultimate place in the financial landscape.

Part of the problem is due to the hybrid nature of the product itself: They're part equity and part commodity, with trading partially governed and cleared through the Options Clearing Corp. This puts the marketing of securities futures in a netherworld -- securities brokers don't quite understand or sometimes don't even offer futures trading, and commodity firms rarely pursue retail stock accounts.

Educating both the providers and users will be crucial to the product's growth. "I liken this to cell phones. People are creatures of habit but at some point the advantages of a product will create a change in behavior and lead to broad usage," said Peter Borish, senior managing director at OneChicago, the leading securities futures exchange.

What They Are

Like an option, one single-stock futures contract represents 100 shares of the underlying stock. But unlike an option's price, which displays nonlinear behavior due to time and volatility, the price of an SSF will closely track the price of the underlying stock, eventually converging at expiration.

SSF contracts have a finite lifespan. A transaction is an agreement between a buyer and seller to purchase or deliver those shares at the expiration date. Of course, positions can be closed out (sold or bought back) anytime prior to expiration. Expiration months run on a quarterly basis: March, June, September, December. Two quarterly and two front serial months will trade at all times for a total of four active expirations.

Short-term interest rates, which affect the cost of carry, are what mostly determine the price of a single-stock futures contract. As the expiration date draws near, that cost nears zero. But don't confuse this with the time premium associated with an option's value. An option is an eroding asset and may expire worthless. A securities future always will expire with a value equal to the current cash market.

Cheaper, Faster

Both of the exchanges that offer SSFs, OneChicago and NQLX, are fully electronic and include futures on not only individual issues but broad ETFs and micro-sector funds. The price increments are in pennies and the bid/ask spreads are comparable to the cash stock market (and typically much narrower than the related options market). And as a new all-electronic exchange, there is no legacy of the specialist system -- the trading systems are both cheaper and more efficient.

The first and most notable advantage over stocks is the added leverage provided by the lower margin and capital requirements. Initial margin requirements for stock futures are just 20% of the cash value of the contract, which is significantly below the 50% requirements for buying or shorting stocks in the cash market. For example, if you buy 100 shares of XYZ at $50, you'd have to put up $2,500. By contrast, buying one XYZ single-stock future would require just $1,000.

This additional leverage can be applied to reduce the cost and yield higher returns. For example, you could create a covered-call position using stock futures. The call options sold will be done on a one-to-one basis with the futures contracts because they both represent 100 shares. Not only will your margin and capital requirements be lower, but the commission cost also may be lower due to the reduced number of contracts traded.

Another important feature is that while stocks have a limited number of shares available to trade (the float), there is no limit on the number of futures contracts that can be made available. This means you'll never be unable to short shares. (In past articles I've talked about using options, specifically simultaneously buying a put and selling a call, to create a synthetic short position in issues with hard-to-borrow shares.)

Borish believes the unlimited pool of available shares is a prime example of how stock futures can create a more efficient market. "Once SSFs are recognized and accepted as a seamless replacement for trading stocks, it will lead to a natural two-sided marketplace," he said. This should provide a nice release valve for hard-to-borrow stocks and help prevent short squeezes or other attempts to manipulate a stock's price. Also, SSFs are not bound by the uptick rule, meaning you can short into a declining price.

Time to Grow

Borish acknowledges that a new business takes time before usage can become widespread. To that end, he has focused the marketing toward professional traders who trade options. "Like any product, you look for the early adopters who recognize and can take advantage of the improvements," he said. These marketing targets -- options market makers, institutions and hedge funds -- are where incremental price improvements and additional basis points can really make a big difference to the bottom line.

OneChicago has been taking its story right to the trading floors and desks of these "need-to-trade" users, and the message is starting to resonate. " When looking to quickly hedge a position, if the liquidity is there, I definitely go with the stock futures," said John McCracken, an independent trader on the Chicago Board Options Exchange.

The problem is that the top five issues make up nearly 60% of the trading volume. That means most of the listings lack the liquidity necessary for assuring execution of a large order. Until investors can see a significant increase in daily trading volume and open interest, most will be hesitant to trade these products. Borish concedes that single-stock futures are really designed for "top-bracket stocks," and can probably really only support 75 to 100 listings.

Single-stock futures can be traded from either a margin security account that you have set up with your stock brokerage firm or through a commodity account. While the firms with direct ties to OneChicago are fairly limited and targeted to professional traders, some mainstream brokers such as Schwab are giving their customers direct access to trading security futures.

I'd suggest using a stock account. It allows for easier identification of offsetting positions as a hedge, reduces margin requirements and helps get the risk manager off your back. Of course, in either case you will be required to sign a risk disclosure statement, similar to the one used in trading options, stating you understand the nature of the risks involved.

To learn more regarding contract specification, brokerage firms that work with the exchange, a list of products available and even analytic tools, I suggest going to the OneChicago Web site.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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