Issue #6
February 2002
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Single Stock Futures by David Katz Until now, the stock and futures markets lived in separate worlds. The stock markets are overseen by the SEC and include only equities. The futures markets are overseen by the CFTC (Commodity Futures Trading Commission), has its own set of rules, which differ significantly from those of the equities markets, and, with the exception of stock index futures and their derivatives, are restricted to tangible commodities, currencies and interest-rate futures. The futures markets were forbidden by law from dealing in individual equities, although a number of indexes, including the S&P, are traded.
With the inception of single stock futures, recently approved by Congress, these worlds are coming closer together. According to CFTC Chairman James Newsome, speaking at the Managed Funds Association Network 2002 meeting in Miami Beach this month, the SEC and CFTC have reached agreement on sharing the regulatory oversight of single stock futures, and trading is expected to be approved to start in April of this year. Chairman Newsome indicated that the level of cooperation between the commissions has been unparalleled.
One of the features distinguishing the stock market from the futures market is the amount of leverage a given transaction can command. In the stock market, leverage is limited by the legally permitted maximum margin, that is, the amount that can be borrowed from the broker to purchase stock. Currently set at 50%, leverage is thus no greater than 2 to 1, and is often less, depending on your broker's estimation of your creditworthiness. That is, for an expenditure of $100, you can control no more than $200 of stock. In the futures market, margin has an altogether different meaning. It is more in the nature of a down payment on a transaction to take place later in time, rather than a loan to finance a current transaction. Since this down payment is often between 10 and 20 percent of the total price, leverage is often 5 or 10 to 1, allowing a $100 outlay to control assets of $500 to $1,000.
Another difference between stock and futures markets is the ease with which a short position can be established, and the length of time for which it can be carried. In the futures market, as opposed to the stock market, it is as easy to go short as to go long. This is especially important to hedgers; that is, those who are trying to protect some asset from market fluctuations.
Single stock futures bridge the gap between these arenas. A new exchange, NQLX, has been formed to trade these instruments. NQLX is a joint venture between Nasdaq, where OTC stocks are traded in the US, and LIFFE, the London International Financial Futures and Options Exchange. An NQLX single stock futures contract will represent 100 shares of the underlying stock, and will be deliverable in March, June, September and December, as well as the nearest two serial months. Pricing will be in US Dollars per share, with a minimum price increment of 1 cent. Although margin rules and tax treatment have not been completely worked out, NQLX intends to set initial margins at 20%, allowing for a leverage of 5 to 1.
An initial group of 50 stocks (33 traded on the New York Stock Exchange and 17 traded on Nasdaq) has been selected by NQLX to pioneer futures trading. Since these are some of the most active stocks on these exchanges, the list is heavily weighted toward high-tech issues (communications, computers, bio-technology and pharmaceuticals). It will be possible to construct hand-tailored, narrow-based indexes using combinations of stock futures, as well as trading the stock futures for their own sake.
The three Chicago commodity and options exchanges have also announced their intention to offer single stock futures contracts, but these will probably not be available until the end of the year. AMEX also has plans to offer these futures. Single stock futures are currently available in the UK, but volumes have been disappointing. If US volumes are more encouraging, it is likely that all of the domestic stock and futures exchanges will eventually offer some kind of single stock futures.
While there are many benefits to be had from trading these futures if you are a money manager, pension plan, large corporation or hedge fund, individual investors would be well advised to steer clear, especially at the beginning. For someone whose experience is limited to dabbling in a few stocks or stock indexes, the game will seem totally unfamiliar, the risks will be enormously greater, and the ability to bail out before incurring severe damage may be restricted. Like commodity futures, this will not be a game for the amateur.
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