It was the early 1980s and Wall Street was mired in a bear market, hardly a propitious time to start trading futures contracts on stock indexes. Still, the Chicago Mercantile Exchange launched the Standard & Poor's 500-stock index contract. Before long, the bull market got started and stock-index futures became not only a big hit but also an integral tool for portfolio management.
Now, as stocks once again struggle to come out of a bear market, the futures crowd is gearing up for an early October launch of another innovative product: single-stock futures. These instruments, which, like equity options, can be used as a conservative hedge or a risky speculation, initially will be offered on about 75 large-cap stocks, including AOL Time Warner (AOL ), Microsoft (MSFT ), and Wal-Mart Stores (WMT ).
Single-stock futures work like this: Say Microsoft is trading at $50 a share on Oct. 1, and you think the price is likely to go up in the next three months. Since each contract is for 100 shares, one contract is worth 50 times 100, or $5,000. But with futures, you don't have to put up the entire amount--just 20%, or $1,000, will do. If the stock goes up to $60, you've made $1,000. That's a 100% profit on a 20% move in the stock.
How does that compare with the alternatives? A call option that gives you the right to acquire 100 shares of Microsoft at $50 for the next three months costs about $550. If the stock goes up $10, to $60, the option should be worth about $1,000. But not all of that is profit. You spent $550 for the option, so your return is $450, or 82%. With futures, your profit goes up dollar for dollar, while with an option, you won't make money until you've earned back the contract cost. Of course, you could always buy Microsoft shares outright, paying $5,000 for 100 shares. In that case, a 10-point upward move earns you $1,000--just a 20% gain on your investment.
Remember, though, that if the stock starts dropping, that long position in a futures contract can quickly turn against you. If the stock drops to $40, your initial $1,000 is gone--and long before that the brokerage firm holding your account would have asked you to put up more margin to maintain your position. In contrast, had you bought an option, your maximum loss is what you paid for it. And if you bought the stock, you have an unrealized loss, but you can still hold on in the hopes of an eventual gain.
You can also use a single-stock futures contract to bet against a stock. You sell, or "short," a contract, and the profit comes as the price drops. So an upward move can eat your margin. If you're a long-term owner of the stock and you don't want to sell, shorting futures may be just the thing to help you hedge your way through a bear market. That way, every dollar down in the stock should be offset by a dollar up in the contract value. "This will be a powerful hedging tool for serious traders," says Tom Ascher, CEO of NQLX, one of two new all-electronic exchanges that was started to trade these futures.
Ascher's unit is a joint venture of the Nasdaq and the London International Financial Futures & Options Exchange. The other new exchange is called One Chicago, launched in tandem by the Chicago Mercantile Exchange, the Chicago Board Options Exchange, and the Chicago Board of Trade.
Single-stock futures aren't trading yet, but they already have critics. "I don't see any purpose in the product," says Ned Bennett, CEO of online trading firm OptionsXpress. But he'll offer them if there's demand.
The timing of the launch isn't great. And single-stock futures haven't been a hit elsewhere. They're already offered at nine exchanges around the world, yet together they account for only 1% of the total trading volume of the index futures market. Still, stock-index futures didn't look too timely when they started, either.
By Pallavi Gogoi