This guide will examine in detail a derivative contract called single stock futures – how they work, their key terminology illustrated by examples, who they benefit, as well as the pros and cons of using them.
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Futures contracts definition
What is a futures contract?
These agreements are standardized for quality and quantity to streamline trading on highly regulated futures exchanges that require transparent contract and pricing data. As a result, the exchange acts as a mediator and facilitator between the parties. In addition, the exchange requires both parties to pay an upfront deposit as part of the contract, known as the initial margin payment.
By purchasing the right to buy, an investor expects to profit from an increase in the underlying asset price (long position). Conversely, the investor intends to benefit from a decline in the underlying asset price by buying the right to sell (short position). The payment and delivery (the transfer of the underlying asset or other settlement of the contract for either a gain or a loss) of the security are made at a future time termed the delivery date.
Because the futures prices are bound to fluctuate daily, the price differences are also settled daily from the margin. If the margin is used up, the contractee must replenish the margin back in the account (maintenance margin). Thus, only the spot price is used to decide the difference on the day of delivery, as all other differences have been previously settled.
Many kinds of financial participants can trade futures contracts, but typically it’s hedgers and speculators. Speculators use futures contracts to bet on the future price of an asset to profit by either going long or short. Hedgers use futures to secure a price today to lessen market volatility between now and when goods are delivered or received.
Finally, arbitrageurs trade futures contracts in or across related markets, benefitting from theoretical mispricings that may exist temporarily.
Single stock futures definition
Since an SSF is a derivative product, its market price is based on the underlying security price plus the carrying cost (holding costs) of interest. As a result, trading SSFs requires a lower margin than buying or selling the underlying security, often in the 20% range, offering investors increased leverage.
Because stock futures contracts are cash-settled, there is no physical delivery of shares once the contract expires. Therefore, upon expiry, profits, as well as losses, will be credited or debited to the account of the contract buyers/sellers in a sum equal to the difference between the contracted amount and the final settlement (closing) price on the last trading day multiplied by the contract size.
The investor takes an offsetting short position to get out of an open long position. Conversely, if an investor has sold a contract and wishes to close it out, buying the contract will offset or close it out.
Lastly, all buyers and sellers of stock futures are required to deposit a margin when opening a position in the market to execute their contractual obligations. If the margin falls below the stipulated level due to unfavorable price movements, the investor will be asked to replenish the margin back to the original level.
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History of SSFs in the United States
In the 1980s, SSFs were banned from any exchange listing merely because the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) could not decide on which regulatory body would have authority over these products.
However, in 2000, President Bill Clinton signed Commodity Futures Modernization Act (CFMA) into law. Consequently, the SEC and the CFMA eventually agreed on a jurisdiction-sharing plan, and SSFs began trading on November 8, 2002. Therefore, single-stock futures could be traded out of either securities or a futures account.
SSFs in the U.S.
Initially, two exchanges offered security futures products, including single stock futures. To start with, in 2000, Nasdaq-LIFFE Markets (NQLX) became the first U.S. exchange established to trade single stock futures but had to close its doors after several years of operation due to a lack of support from Nasdaq.
Next, in April 2001, was OneChicago, a joint venture of three previously-existing Chicago-based exchanges, the Chicago Board Options Exchange, Chicago Mercantile Exchange, and the Chicago Board of Trade.
Unfortunately, it was the last U.S. exchange to offer single stock futures as it ceased trading in September 2020. As a result, SSFs are no longer offered in the U.S. Several other U.S. exchanges and ECNs have implied that they would begin offering single stock futures but never completed plans to do so.
Global SSF trading
It seems that the U.S., compared to overseas exchanges, missed the boat with its rollout of SSFs. And while the reception for single stock futures was favorable when they launched, activity faded over time, and ultimately, SSFs ceased trading on the U.S. market. However, this derivative continues to attract global interest. Trading in Europe, which preceded that in the U.S., remains relatively active.
By 2020, SSFs were traded on several exchanges worldwide:
- ASX (Australia);
- Athens Derivative Exchange;
- Bolsa de Valores de Colombia;
- Borsa Istanbul;
- Borsa Italiana;
- BSE (India);
- Budapest Stock Exchange;
- Eurex;
- Euronext;
- Hong Kong Exchanges and Clearing;
- ICE Futures Europe;
- JSE Securities Exchange (Johannesburg);
- Korea Exchange;
- MEFF;
- Mexican Derivatives Exchange;
- Moscow Exchange;
- Nasdaq Exchanges Nordic Markets;
- National Stock Exchange of India;
- Singapore Exchange.
Currently, South Africa boasts the world’s largest SSF market, trading an average of 700,000 contracts daily.
Single stock futures: Key terminology
Each SSF contract is standardized and contains these elements:
- Contract multiplier: contract size, typically 100 shares of the underlying stock;
- Expiration date: Generally follow the quarterly cycle (March, June, September, and December). The expiries for long-term contracts can range from six to eight months, depending on the time of the year;
- Minimum price fluctuation: 1 cent X 100 shares = $1;
- Last trading day: Third Friday of the expiration month or the second last trading day of the contract month;
- Margin Requirement: Typically 20% of the stock’s cash value;
- Delivery of shares: By a set expiration date. However, most contracts are closed before expiration.
How do single stock futures work?
SSFs can be traded freely before their expiration dates, and the pricing of the contracts varies according to supply and demand. However, they will generally trade at a premium to the actual share price to adjust for interest rates. Thus, the premium reflects the interest earned on the capital saved by not putting out the entire value of the underlying stock (adjusted for any dividends that are scheduled to occur before the expiration date).
As with all standard futures contracts, single stock futures give the holder the obligation to take delivery of shares of the underlying asset at the contract’s expiration date. Likewise, the contract seller is responsible for delivering those assets by expiration.
SSF pricing
The SSF trading price is based on the price of the underlying security plus the carrying cost of interest, discounted for any dividends that are scheduled to occur before the expiration date. Changes in market value can be brought about by transaction costs (commission), borrowing costs, and dividend assumptions.
Formula
Single Stock Futures (SSF) may be priced using the following calculation:
Futures price = Stock Price * (1 + (Annualized Interest Rate * Days to Expiration/365)) – Present Value of Dividends due before expiration.
Margin
Single stock futures are typically traded on margin, which the brokerage firm holds toward the contract settlement. The margining process guarantees the performance of each trade and allows the exchange to guard itself against any individual party failing to meet its obligations. Thus, the margin can be considered a “good faith” deposit.
The margin requirement in an SSF affects both buyers (long) and sellers (short) and represents the initial and maintenance requirement. These funds remain on deposit as long as the position is open.
While the investor returns the initial margin when the position is closed out or the contract expires. Initial margin can vary, but brokers generally mandate only 20% of the value of the underlying stock to be put up as collateral. Still, the individual brokerage house can require additional funds.
You must maintain the minimum account balance before your broker will force you to deposit more funds or close out your position, known as a “margin call.” Margin calls can result in the investor liquidating stocks or adding more cash to the account. Additionally, brokers may be able to sell your securities without consulting you.
The margin requirement for SSFs is continuous, calculated by the broker on each business day for each position.
Dividends
SSF holders do not receive dividends that are paid by the underlying asset, nor do they have voting rights.
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Uses and participants of SSFs
Single stock futures offers greater leverage and short-taking than trading in the underlying stock. Additionally, trading in single stock futures is primarily used to hedge or speculate on the price movement of the underlying security. For example, a producer of rice could use futures to lock in a specific price and reduce risk, or any investor could speculate on the price activity of rice by going long or short using futures.
Single stock futures example: Speculator
Bullish investor
The initial margin requirement was only $400 ($20 x 100 = $2,000 x 20% = $400). So the investor earned an 80% return on the margin deposit, demonstrating the substantial amount of leverage used in SSF trading.
Bearish investor
The total profit arrived at $1,000 on an initial margin requirement of $1,000 ($50 x 100 = $5,000 x 20% = $1,000), translating to a hefty 100% return on the margin deposit. Naturally, leverage works both ways, making SSFs particularly risky.
Single stock futures example: Hedger
To hedge a long position in an asset, an investor needs to sell an SSF contract on that very same asset. Then, if the asset falls in price, profits in the SSF will work to offset those losses in the underlying security. However, importantly, this is solely a temporary solution since the SSF will expire.
Now, let’s imagine an investor who bought 100 shares of stock ABC at $40. In July, the stock is trading at $45. Although pleased with the unrealized gain of $5 per share, the investor is worried that the profits could be wiped out in one unlucky day. And selling won’t be an option because they want to keep the stock until September to receive an upcoming dividend payment.
Instead, the investor sells a $45 September SSF contract to hedge the long position, locking in the $5-per-share gain whether the stock rises or falls. Then, in August, the investor sells the stock at the market price and buys back the SSF contract.
Until the SSF expires in September, the investor will have a net value of the hedged position of $4,500. Unfortunately, though, if the stock price dramatically jumps, the investor will still be locked in at $45 per share, forfeiting their potential profits.
SSFs vs. options
There are a few fundamental differences between trading SSFs and stock options contracts:
- Long options position: In options contracts, the investor has the option to buy or deliver the shares when in a long call or long put position. In comparison, in a long SSF position, the investor must deliver the stock;
- Market movement: Options traders use the delta (risk metric) to measure the relationship between the options premium and the underlying stock price. Often an option contract’s value may fluctuate independently of the stock price. Conversely, an SSF contract will follow the underlying stock’s movement reasonably closely;
- The cost: When an options trader takes a long position, they pay a premium for the contract, which declines in value over time. Then, at expiration, unless the options contract is in the money, it is rendered worthless – the investor has lost the entire premium (Note: like single stock futures, options can be closed before expiration). SSFs, on the other hand, require an initial margin deposit and a specific cash maintenance level.
Pros and cons of single stock futures
SSFs are a form of derivative contract which takes their value from the value of an underlying asset. Accordingly, the risks and benefits are similar to other derivative products in that high leverage can both amplify losses as well as gains.
Pros
- Low transaction costs: the stock transaction costs are low relative to purchasing or selling the total underlying shares;
- Ease of shorting: establishing a short position in a stock futures contract is a relatively straightforward process, allowing investors to benefit from an anticipated fall in the value of the underlying stock. In addition, short-selling SSFs can be less costly and may be executed at any time (there are no uptick rules);
- Increased leverage: As the margin required to open a stock futures position is only a sliver of the value of the underlying security, hedging/trading activities can be conducted with a smaller cash outlay;
- Flexibility: investors can use these derivative products to speculate, hedge, or create spread strategies;
- Speculative objectives: the single stock futures are the ideal instruments to bet on the future price of an asset to profit by either going long or short;
- Hedging purposes: investors who own shares in a company’s stock can also trade the single stock futures for additional protection for their original investments against potential market volatility or short-term declines in the price of the underlying asset;
- Exchange-traded contracts: The single stock futures are exchange-traded and standardized contracts marked by regulatory oversight;
- Lower taxes: since SSFs are futures contracts, the earnings from your futures trades are taxed at a different and lower rate than trading actual stocks.
Cons
- Risk: single stock futures involve a high degree of leverage. As a result, losses from SSF trading may considerably exceed the investor’s initial margin funds and may demand payment of additional margin funds on short notice. Failure to do so can result in the investor’s position being liquidated and liability for any deficit resulting from said position;
- Changing margin requirements: SSFs are investments that require investors to monitor their positions reasonably closely. Since SSF accounts are adjusted daily for margin requirements, there is the likelihood that the brokerage firm might issue a margin call, asking the investor to choose whether to deposit additional funds or to close the position quickly;
- No shareholder privileges: The SSF owner has no voting rights and no rights to dividends.
- Lack of activity: Notable lack of trading activity compared to other futures products or derivatives, making them a less liquid instrument than the actual stock they represent.
Final thoughts on SSFs
SSFs offer greater leverage, better flexibility, and short-selling when compared to solely trading in the underlying stock or even options trading. In addition, SSFs allow investors to bet on moves in an asset without devouring up as much capital as buying the actual shares.
Nevertheless, potential investors should carefully examine these instruments’ risk/reward profiles to ensure they’re suitable for their goals. Moreover, it is essential to keep in mind that increased leverage – as well as boosting profits – will amplify losses, too.
FAQs about single stock futures
What are SSFs?
A single stock future (SSF) is a contract to deliver typically 100 shares of a specified stock on a pre-determined expiration date. As derivative products, there is no physical delivery of shares when the contract expires, and instead, they are cash settled.
What is margin in SSFs?
Single stock futures are generally traded on margin, which the brokerage firm holds toward the contract settlement, guaranteeing each trade’s performance and allowing the exchange to guard itself against any individual party failing to meet its obligations. Margin affects buyers and sellers and represents the initial (typically 20%) and maintenance requirements that remain on deposit as long as the position is open.
Where can SSFs be traded?
SSFs are traded in various financial markets, including the United Kingdom, Spain, and India. Currently, South Africa boasts the world’s largest SSF market, trading an average of 700,000 contracts daily. In the U.S. SSFs are no longer offered.
What are some of the benefits of trading SSFs?
SSFs can be used to hedge against potential market volatility on your open equity positions or to speculate on the price fluctuations of the underlying stock. In addition, they are relatively inexpensive compared to purchasing a stock outright, and high leverage means that gains can be just as significant.
What are some of the risks involved?
The high leverage of SSFs is certainly a doubled ended sword, meaning that losses from SSF trading may considerably exceed the investor’s initial margin funds. Moreover, unlike owning the underlying stock, the SSF owner has no voting rights and no rights to dividends.
