On July 24 the Dow Jones industrial average sank toward 7500 before staging a dramatic rally. It was a thrill ride for active traders, while most investors recoiled in amazement.
That afternoon the Securities and Exchange Commission, pausing in its campaign to repair confidence in the stock market, voted with no fanfare to open yet another playground for risk-takers.
The SEC, following earlier action by the Commodity Futures Trading Commission, took a final step toward trading in single-stock futures–futures contracts on individual stocks and narrow stock indexes.
A futures contract grants the buyer or seller the obligation to receive or deliver something–corn, Treasury bonds, pesos– at a point in the future for a specified price. Futures are used widely, from farming to banking, to speculate and offset risk.
Futures trading based on broad-based stock indexes, such as the Standard & Poor’s 500 index, the Dow Jones industrial average and the Nasdaq 100 index, has been under way for years, for investors who want to be in the stock market without owning companies.
Soon, you’ll be able to trade futures on particular stocks, such as International Business Machines.
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Proponents of single-stock futures focus on the ease by which investors can bet on declines in stock prices, a process known as selling short.
“Primarily, the benefit is you can short stock far more easily,” said Joseph Murphy, chief executive officer of Refco Global Futures. “What this is doing is leveling the playing field between the big institutional investors and the individual investors,” said Murphy.
“I don’t think there’s ever been a time that is more important for individuals to utilize a tool that can preserve their wealth, because the stock market has been so volatile and so negative,” he said.
Single-stock futures were banned nearly 20 years ago but authorized in legislation enacted at the end of 2000. Chicago’s futures and options exchanges lobbied heavily for the bill, which also included a major regulatory loophole for energy traders such as Enron.
Last year’s planned rollout of single-stock futures hit several snags, including difficulties in melding regulations at the SEC and CFTC; back-office problems at brokerage firms in merging futures and securities account systems; and, of course, the stock market swoon that blunted appetites for risk.
The SEC vote last month means trading in single-stock futures by individual investors could debut as soon as next month–though it may be next year before promoters of the concept develop traction.
Indeed, no one knows whether single-stock futures will appeal to individual investors. Without broad public participation the concept could be a costly disaster for sponsoring exchanges, including OneChicago, a joint venture of Chicago’s futures and options exchanges.
If single-stock futures attract a following, no one knows to what extent they would become the tail that wags the dog of underlying stocks at times of market stress–a persistent allegation made against stock options and stock index futures.
The greatest enthusiasm for the product lies in the futures industry, which sees a vast untapped market of active stock market investors who may have dabbled in options but have not ventured into futures.
Traditional stock brokerage firms and financial advisers are cautious if not outright hostile.
“I don’t see the utility of the product for individual investors,” said James Knight, vice president and manager of the options and futures trading department at Raymond James Financial Services and a member of the Securities Industry Association’s options committee.
“I can’t imagine it being a good retail product at all,” he said. “Any good product has to have retail behind it or it can’t be successful.”
Nonetheless, the primary message that investors looking for new ideas will hear from advocates of single-stock futures is that they are cheap to deal in and easy to use.
Under margin rules adopted by the SEC and CFTC, only 20 percent of the value of a single-stock futures investment needs to be put up as security, compared to the minimum 50 percent margin requirement in stock investments.
You’ll hear that single-stock futures are cleaner and simpler tools than options on individual stocks. Options grant the holder the right, not the obligation, to buy or sell the underlying security.
Promotional material prepared by Nasdaq Liffe Markets, one of the new exchanges formed to deal in single-stock futures, addresses current investor frustration: “Nothing will put you back in control of your portfolio and your trading performance more.”
“If this was available two years ago, I might be retiring right now,” remarked Ira Krulik, director of listed derivatives at Credit Suisse First Boston.
Education needed
In hindsight, many investors would love to have been able to profit from the market slide by selling stock futures. But casual investors making one-way bets on stock prices must beware.
“Individuals with stocks or funds in a cash account really need to educate themselves. It’s unrealistic to look at them as early adopters,” said Howard Simons, a professor at Illinois Institute of Technology and an adviser to Nasdaq Liffe Markets.
Unlike the stock market, the futures market is a zero-sum game.
If you bet wrong and fail to dump the contract before it expires, you could be forced to buy IBM shares at $90, when the stock is selling on the New York Stock Exchange for $70.
“Historically, there are more people who do badly than do well,” said Geoffrey Aronow, a lawyer specializing in financial regulation at Arnold & Porter in Washington.
“A small number of people who know what they’re doing end up on the plus side,” he said.
Regulators will require that customers sign a new risk disclosure document, currently in development.
“The upfront disclosure rules about the risks inherent in these markets are extremely important,” said CFTC Chairman James Newsome. “The customer has the responsibility of reading the disclosure and understanding the level of risk.”
Most strategies for which single-stock futures might play a role require multidimensional thinking–as opposed to one-dimensional buy or sell decisions.
Murphy at Refco said one strategy involves trading in pairs. A futures market trader might buy oil futures and help pay for the purchase by selling futures in the shares of London-based energy giant BP.
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“You might be bearish on BP but bullish on overall oil prices,” he said.
A strategy that could appeal to stock market investors involves fine-tuning a core portfolio, such as an investment in the Standard & Poor’s 500 index. Investors who foresaw the tech wreck coming two years ago could have held their S&P index fund but sold futures in a handful of large-capitalization technology and telecommunications stocks.
Also, if you’ve been holding a stock for a while and have a large embedded capital gain but believe the company is heading for a rough patch, you could hold your investment–and thereby avoid capital gains taxes–while you sold futures in the stock during the down cycle, Krulik said.
Such occasional uses of single-stock futures will not provide the market liquidity the new product needs to prosper. Short-term trading strategies will determine its viability.
Price spreads
Day traders who thrive on minute-by-minute market action have been switching from individual stocks to stock-related futures in search of wider price spreads between bids to buy and offers to sell, said John Lynch, director of product development at Austin, Texas-based CyberTrader, an online direct trading unit of Charles Schwab Corp.
“You have people entering and exiting strategies rather quickly, the spread being adequate enough where if they were to buy and sell in a relatively short fashion there would be enough profit,” he said.
Overall, single-stock futures present a new category of investment product whose price action could offer brief profit opportunities as it varies from prices of related products.
“We’re constantly going to see that type of interaction of particular single-stock futures versus its option versus its stock,” Lynch said.
But multilevel strategies employing single-stock futures, as well as naked bets with the new product, will not be around long if investors do not make money.
“If people start getting burned in this product, it’s not going to be a pretty thing for the financial-services community,” said Krulik.