Single Stock Futures (SSF) allow investors to profit in both bull and bear markets and hedge against some of the weak performers in their portfolio.
SSF are futures traded on individual stocks. Holding a SSF guarantees the sale of purchase of its underlying share upon expiry of its contract at an agreed price. As it derives its value from the price of its underlying security, it’s assumed the SSF is similar to a warrant. However, there’s a distinct difference; the SSF doesn’t carry a strike price (the stated price per share for which the underlying stock may be purchased by the option i.e. warrant holder upon exercise of the option contract). This means that by holding a single SSF, investors either pay or receive payment for 1,000 underlying shares, which is its standard contract size, upon maturity. Because cash payment is received or made, actual physical shares don’t change hands. This process is called a cash settlement.
Before being permitted to trade SSFs, investors must maintain cash reserves in a trading account that is equivalent to 10% – 25% of the underlying stock’s value. This ‘initial margin’ functions like a good-faith deposit, providing assurance those investors can meet their obligations if the SSF moves against their position (that is, the price falls after the SSF has been acquired).
The low margin requirement to trade a SSF provides the opportunity for an investor to trade the same amount of stock that a traditional investor does but for less than one-fifth of the cost and compared to buying shares on margin, SSFs require less money to trade.
So, SSFs free up more funds for investments. Meaning, lower margins indicates greater leverage and greater leverage allows investors access to more investment products with a smaller capital.
Leverage is a powerful benefit but do remember that this means you could lose large amounts as well. It’s important that investors monitor the performance of SSFs closely as the value can surge and collapse very quickly.
Gains and losses are posted to the SSFs trading account at the end of each business day. This procedure, called ‘mark-to-market’, is performed by the futures broker that conducts the trading transactions. If performance of the SSF runs contrary to the position that was taken, additional funds must be added to maintain the minimum margin requirements and to continue trading the SSF. Failure to meet this margin would result in forced liquidation of the SSF contract.
Many industry participants believe trading SSFs is straightforward. Buy or go ‘long’ on a SSF if you expect the price of its underlying share to appreciate. Should the price going down, then sell or ‘short’ the SSF.
The ability to ‘short’ a SSF is often cited as its main advantage. This term refers to selling a security that the investor doesn’t own. This is similar to regulated short selling (RSS) for selected stocks, which is slated to begin in the third quarter of the year, but there’s one big drawback with RSS. The ‘up tick’ rule only allows investors to short the share if its last price movement was ‘up’. This rule is designed to keep short-sellers from driving down the price of a falling share even further than it would go otherwise. SSFs are exempt from this rule as they can be sold ‘short’ at any time.
This is why SSFs can be used in both bull and bear markets. During volatile periods, SSFs offer investors a quick way to neutralize risk by hedging. Bear in mind, a complete SSF trade consists of a buy and a sell transaction. Thus, the ‘sell’ must be followed with a ‘buy’ to close the position. If the contract is held till maturity, your position will be evaluated with the price of the SSF on that particular day. If your positions generate a loss, you’ll be asked to top up your trading account. On the other hand, if a profit has been made, you’re allowed to withdraw funds. Like other derivatives, trading in and out of SSFs is done very quickly, either within a single trading session or over a few days. One such strategy called spread trading, can be applied when the investor believes the price of one share will fall or rise in relation to another stock. By buying a SSF contract on a share that is expected to rise and going ‘short’ with a SSF on the other stock, the investor can profit from the spread between both securities.
These strategies are supported by the low cost of trading. SSFs are extremely cheap at approximately $10 per transaction, which is much lower than general share transaction fees.
While SSFs are not an overnight success, the development of today’s investing environment calls for many different tools, which make it possible for the informed investor taking advantage of different market conditions. In conclusion, investors should take note of the SSFs benefits while being aware of its risks.