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Printer-Friendly Security Futures – Know Your Risks, or Risk Your Future

November 4, 2002

Security futures are among the newest - and potentially riskiest - financial products available in the United States. Recent changes in federal regulations now permit trading in futures contracts on single stocks (also known as single stock futures or SSFs) and narrow-based security indices (see definition below). This article describes what security futures are, how they differ from stock options, some of the risks they can pose, and how they are regulated. You should also read the Security Futures Risk Disclosure Statement before trading security futures.

Although discussed in greater detail below, security futures involve a high degree of risk and are not suitable for all investors. As with any investment, if you don't understand it, you shouldn't buy it. You could lose a substantial amount of money in a very short period of time. The amount you may lose is potentially unlimited and can exceed the amount you originally deposit with your broker. This is because trading security futures is highly leveraged, with a relatively small amount of money controlling assets having a much greater value. Investors who are uncomfortable with this level of risk should not trade security futures.

Existing Futures Contracts Futures contracts have been around for some time. In addition to security futures, futures contracts exist for a variety of agricultural commodities and energy products, precious metals, foreign currencies, and financial instruments. In fact, futures contracts on broad-based stock indexes, such as the S&P 500, have been trading for several years.

Security Futures Basics

What's a security futures contract?

A security futures contract is a legally binding agreement between two parties to buy or sell a specific quantity of shares of an individual stock or a narrow-based security index at a specified price, on a specified date in the future (known as the settlement or expiration date). If you buy a futures contract, you are entering into a contract to buy the underlying security and are said to be "long" the contract. Conversely, if you sell a futures contract, you are entering into a contract to sell the underlying security and are considered "short" the contract.

 

Security Futures Contract Specifications Contract size - Typically, one single stock futures contract will represent 100 shares of the underlying stock. A narrow-based index futures contract will represent the value of the index times a dollar amount set by the exchange. Contract month - The month when the contract expires. There will be several different contract months available for trading at any one time, and the number of contract months may vary from exchange to exchange. Last trading day - The last day during the contract month when the contract will trade. This is usually the third Friday in the month. Manner of settlement - Security futures may be settled by physical delivery of the underlying security or cash settlement. Most security futures contracts require physical delivery.

Offsetting Transactions

Prior to expiration, you can realize your current gains or losses by executing an offsetting sale or purchase in the same contract (i.e., an equal and opposite transaction to the one that opened the position).

Example: Investor A is long one September ABC Corp. futures contract. To close out or offset the long position, Investor A would sell an identical September ABC Corp. contract.

Investor B is short one October XYZ Corp. futures contract. To close out or offset the short position, Investor B would buy an identical October XYZ Corp. contract. 

Contract Expiration and Delivery

Any futures contract that hasn't been liquidated by an offsetting transaction before the contract's expiration date will be settled at that day's settlement price (see definition below). The terms of the contract specify whether a contract will be settled by physical delivery - receiving or giving up the actual shares of stock - or by cash settlement. Where physical delivery is required, a holder of a short position must deliver the underlying security. Conversely, a holder of a long position must take delivery of the underlying shares.

Where cash settlement is required, the underlying security is not delivered. Rather, any security futures contracts that are open are settled through a final cash payment based on the settlement price. Once this payment is made, neither party has any further obligations on the contract.

Margin & Leverage

When a brokerage firm lends you part of the funds needed to purchase a security, such as common stock, the term "margin" refers to the amount of cash, or down payment, the customer is required to deposit. By contrast, a security futures contract is an obligation not an asset and has no value as collateral for a loan. When you enter into a security futures contract, you are required to make a payment referred to as a "margin payment" or "performance bond" to cover potential losses.

For a relatively small amount of money (the margin requirement), a futures contract worth several times as much can be bought or sold. The smaller the margin requirement in relation to the underlying value of the futures contract, the greater the leverage. Because of this leverage, small changes in price can result in large gains and losses in a short period of time.

Example: Assuming a security futures contract is for 100 shares of stock, if a security futures contract is established at a contract price of $50, the contract has a nominal value of $5,000 (see definition below). The margin requirement may be as low as 20%, which would require a margin deposit of $1,000. Assume the contract price rises from $50 to $52 (a $200 increase in the nominal value). This represents a $200 profit to the buyer of the futures contract, and a 20% return on the $1,000 deposited as margin.

The reverse would be true if the contract price decreased from $50 to $48. This represents a $200 loss to the buyer, or 20% of the $1,000 deposited as margin. Thus, leverage can either benefit or harm an investor. 

Note that a 4% decrease in the value of the contract resulted in a loss of 20% of the margin deposited. A 20% decrease in the contract price ($50 to $40) would mean a drop in the nominal value of the contract from $5,000 to $4,000, thereby wiping out 100% of the margin deposited on the security futures contract.

Minimum margin requirements for security futures are set by law at 20% of the contract's value, calculated daily, although exchanges can increase this level or adopt different margin requirements based on risk. In addition, brokers can and sometimes do establish margin requirements higher than these minimums.

Adverse price movements that reduce the reserve below a specified level will therefore result in a demand that you promptly deposit additional margin funds to the account. For example, the 4% decrease in the value of the contract that resulted in the loss of 20% of the margin deposit would reduce the margin deposit to $800. Therefore the account holder would need to deposit $160 in the margin account to raise the margin level back up to 20% of the current value of the contract ($4,800). Because of the always-present possibility of margin calls, security futures contracts are not appropriate if you cannot come up with the additional funds on short notice to meet margin calls on open futures positions. If you fail to meet a margin call, your firm may close out your security futures position to reduce your margin deficiency. If your position is liquidated at a loss, you will be liable for the loss. Thus, you can lose substantially more than your original margin deposit.

Gains & Losses

Unlike stocks, gains and losses in security futures accounts are posted to your account every day. Each day's gains are determined by the settlement price set by the exchange. If due to losses your account falls below maintenance margin requirements, you will be required to place additional funds in your account to cover those losses.

Tax Implications

The tax consequences of a security futures transaction may depend on the status of the taxpayer and the type of position (that is, long or short, covered or uncovered). For example, for most individual investors, security futures are not taxed as futures contracts. Short security futures contract positions are taxed at the short-term capital gains rate, regardless of how long the contract is held. Long security futures contracts may be taxed at either the long-term or short-term capital gains rate, depending on how long they are held. For dealers, however, security future contracts are taxed like other futures contracts at a blend of 60% long-term and 40% short-term capital gains rates. Depending on the type of trading strategy that is used, there can be additional or different tax consequences too. 

Caution! Taxes are a complicated matter. Consult your tax adviser before trading security futures. 

Where Do Security Futures Trade?

Currently, the following exchanges have announced that they will start trading security futures in 2002:

• Nasdaq Liffe Markets
• OneChicago

You should check with your broker about when trading starts on the various exchanges.

Variety and Fungibility of Security Futures Contracts

Contract specifications may vary from contract to contract as well as from exchange to exchange. For instance, most security futures contracts require you to settle by making physical delivery of the underlying security, as opposed to making a cash settlement. Carefully review the settlement and delivery conditions before entering into a security futures contract.

At this time, security futures traded on one exchange are not "fungible" with security futures traded on another exchange. This means you will only be able to offset a position on the exchange where the original trade took place - even though a better price may be available for a comparable futures contract on the same underlying security or index on another exchange.

Differences Between Security Futures and Stock Options

Although security futures share some characteristics in common with stock options, these products differ significantly. Most importantly, an option buyer may choose whether or not to exercise the option by the exercise date. Options purchasers who neither sell their options in the secondary market nor exercise them before they expire will lose the amount of the premium they paid for each option, but they cannot lose more than the amount of the premium. A security futures contract, on the other hand, is a binding agreement to buy or sell. Based upon movements in price of the underlying security, holders of a security futures contract can gain or lose many times their initial margin deposit.

Security Futures Risks

All security futures contracts involve risk, and there is no trading strategy that can eliminate it. Strategies using combinations of positions, such as spreads (see definition below), may be as risky as outright long or short futures positions. Trading in security futures requires knowledge of both the securities and the futures markets. Before you trade security futures, you should read the Security Futures Risk Disclosure Statement. And bear in mind the following specific risks involved when trading security futures contracts:

• Trading security futures contracts may result in potentially unlimited losses that are greater than the amount you deposited with your broker. As with any high-risk financial product, you should not risk any money that you cannot afford to lose, such as your retirement savings, medical and other emergency funds, funds set aside for education or home ownership, or funds required to meet your living expenses.
  
  
• Be cautious of claims that you can make large profits from trading security futures. Although the high degree of leverage in futures can result in large and immediate gains, it can also result in large and immediate losses. As with any financial product, there is no such thing as a "sure winner."
  
  
• Because of the leverage involved and the nature of futures transactions, you may feel the effects of your losses immediately. Unlike holdings in traditional securities, gains and losses in security futures are credited or debited to your account on a daily basis at a minimum. Because of daily market moves, your broker may require you to have or make additional funds available. If your account is under the minimum margin requirements set by the exchange or the firm, your position may be liquidated at a loss, and you will be liable for any deficit in your account.
  
  
• Under some market conditions, it may be difficult or impossible to hedge or liquidate a position. If you cannot hedge or liquidate your position, any existing losses may continue to mount. Even if you can hedge or liquidate your position, you may be forced to do so at a price that involves a large loss. This can occur, for example:
• • If trading is halted due to unusual trading activity in either the security futures contracts or the underlying security,
    
    
  • If trading is halted due to recent news events involving the issuer of the underlying security,
    
    
  • If computer systems failures occur on an exchange or at the firm carrying your position, or
    
    
  • If the market is illiquid and therefore doesn't have enough trading interest to allow you to get a good price.
    
    
• Under some market conditions, the prices of security futures may not maintain their customary or anticipated relationships to the prices of the underlying security or index. This can occur, for example, when the market for the security futures contract is illiquid and lacks trading interest, when the primary market for the underlying security is closed, or when the reporting of transactions in the underlying security has been delayed. For index products, this could also occur when trading is delayed or halted in some or all of the securities that make up the index.
  
  
• You may experience losses due to computer systems failures. As with any financial transaction, you may experience losses if your orders cannot be executed normally due to systems failures on a regulated exchange or at the firm carrying your position. Your losses may be greater if your brokerage firm does not have adequate back-up systems or procedures.
  
  
• Placing contingent orders, if permitted, such as "stop-loss" or "stop-limit" orders, will not necessarily limit your losses to the intended amount. Market conditions may make it impossible to execute the order or to get the stop price.
  
  
• Day trading strategies involving security futures pose special risks. As with any financial product, seeking to profit from intra-day price movements poses a number of risks, including increased trading costs, greater exposure to leverage, and heightened competition with professional traders.

Security Futures Regulation and Investor Protection

Who regulates security futures?

The Commodity Futures Modernization Act (CFMA) governs the regulation of security futures. Under the CFMA, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) will jointly regulate security futures. In addition, FINRA, the National Futures Association (NFA), and the security futures exchanges have regulatory responsibilities and authority over their members. These organizations are subject to SEC and CFTC oversight.

Finding and Choosing a Broker

As an individual investor, you cannot trade directly on an exchange. Security futures transactions for individual investors must be handled by a broker. Most brokers are honest, competent professionals, and there are regulators like FINRA, to help make sure that the few who are not are identified and disciplined - sometimes even barred from the industry.

Before you do business with any security futures professional or firm, you should check out their background. Both FINRA BrokerCheck and the NFA's Background Affiliation Status Information Center (BASIC) offer online access to important information about your broker or firm. These sites can provide a wealth of information about the professional background, business practices, and conduct of firms and brokers. Your state securities regulator also may have additional information about securities professionals.

But there is more to finding a broker than knowing which ones might not be trustworthy. The key is finding the broker and firm that make you feel comfortable and best meet your personal financial needs.

Security Futures Account Protection

Security futures positions may be held in either a securities or futures account. The protections for your funds and security futures positions differ depending on whether the account is a securities account or a futures account. Your brokerage firm must tell you whether your security futures positions will be held in a securities account or a futures account. You also may have a choice about which type of account to hold your funds and positions. You should thoroughly understand the regulatory protections available to your funds and positions if your firm fails. The regulatory protections for your funds in a brokerage firm's failure will vary depending, for example, on whether you are trading through a securities account or a futures account.

Protections for Securities Accounts - If you hold security futures contracts in a securities account, SEC rules prohibit a brokerage firm from using your funds and securities to finance its business. As a result, the brokerage firm is required to set aside funds equal to the net of all its excess payables to its customers (money the firm owes customers) over receivables from customers (money customers owe the firm). These rules also require the firm to segregate (hold separately) a customer's fully paid and excess margin securities.

If the brokerage firm becomes insolvent, the Securities Investor Protection Corporation (SIPC) protects cash and security futures held in a securities account. Most brokers who are registered with the SEC are SIPC members; those few that are not must disclose this fact to their customers. To find out if your brokerage firm is a member of SIPC, you can check SIPC's database.

SIPC coverage is limited to $500,000 per customer, including up to $100,000 for cash. This coverage is limited to protecting funds and securities if the broker holding these assets becomes insolvent; these protections do not cover market losses. To learn more, visit the FINRA Web site on SIPC protection.

Protection for Futures Accounts - Cash held in a futures account must be held in segregation, i.e., separately from the brokerage firm's own funds. The firm cannot use your funds to margin or guarantee the transactions of another customer. Nor can the firm borrow or otherwise use your funds for its own purposes. The firm must add its own funds to the segregated account to cover another customer's debits or deficits. If the firm becomes insolvent, you may not be able to recover the full amount of your funds. Your account is not insured; however, customers with funds in segregation receive priority in bankruptcy proceedings.

What to do When Problems Arise

If you believe you have been wronged or see a mistake in your account, act quickly. Immediately question any transaction you do not understand or did not authorize. Don't be timid or ashamed to complain. The securities industry needs your help so it can operate successfully. Here are the steps you should take:

• If you think it's a minor mistake, talk to your broker. This may be the fastest way to resolve the problem.
  
  
• If you can't resolve the problem with your broker or you believe your broker engaged in unauthorized transactions or other serious misconduct, report the matter in writing to the firm's management or compliance department.
  
  
• If you and your firm still can't resolve the problem, you have several options for resolving your dispute:

Caution! Be aware that certain state and federal laws limit the time you may have for filing a lawsuit, arbitration or CFTC reparation claim. 

Additional Resources

FINRA's Security Futures Page

NFA's Security Futures: An Introduction to Their Risks 

Checklist: Before You Trade   Read the Security Futures Risk Disclosure Statement.   Check your broker's background by visiting either FINRA BrokerCheck or the NFA's Background Affiliation Status Information Center (BASIC).   Realize that security futures will expire and, unless you offset your position, you may have to deliver or accept delivery of the underlying security.   Have access to funds in case your losses exceed your original investment   Understand the need to follow closely the price fluctuation of the underlying stock for any futures contract you might buy or sell.

Glossary

Futures contract - a futures contract is (1) an agreement to purchase or sell a commodity for delivery in the future; (2) at a price determined at initiation of the contract; (3) that obligates each party to the contract to fulfill it at the specified price; (4) that is used to assume or shift risk; and (5) that may be satisfied by delivery or offset.

Narrow-based security index - In general, an index that has any one of the following four characteristics: (1) it has nine or fewer component securities; (2) any one of its component securities make up more than 30% of its weighting; (3) the five highest weighted component securities together make up more than 60% of its weighting; or (4) the lowest weighted component securities making up, in the aggregate, 25% of the index's weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million).

Nominal value - The face value of the futures contract, obtained by multiplying the contract price by the number of shares or units per contract. If XYZ stock index futures are trading at $50.25 and the contract is for 100 shares of XYZ stock, the nominal value of the futures contract would be $5,025.

Settlement price - 1) The daily price that the clearing organization uses to mark open positions to market for determining profit and loss and margin calls and for invoicing deliveries in physical delivery contracts, 2) The price at which open cash settlement contracts are settled on the last trading day and open physical delivery contracts are invoiced for delivery.

Spread - 1) Holding a long position in one futures contract and a short position in a related futures contract or contract month in order to profit from an anticipated change in the price relationship between the two, 2) The price difference between two contracts or contract months.