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 equity stocks (also known as single stock futures or SSFs). Futures are different than options, and it is important to understand futures before considering investing in them.
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. If you are not an experienced investor and have a significant net worth and your financial advisor has recommended that you invest in futures, you may want to speak to an attorney about these recommendations as this recommendation was likely unsuitable.
The following is a primer on securities futures, the risks that they can pose, and how they are currently regulated. For more information on securities futures, visit the FINRA website at http://www.finra.org/Investors/InvestmentChoices/P005912.
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.
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.
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?
As of 2002, the following exchanges trade security futures:
• Nasdaq Liffe (now Nasdaq OMX)
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:
o If trading is halted due to unusual trading activity in either the security futures contracts or the underlying security,
o If trading is halted due to recent news events involving the issuer of the underlying security,
o If computer systems failures occur on an exchange or at the firm carrying your position, or
o 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.
If you have questions about securities futures, or believe that you are the victim of securities fraud, The White Law Group may be able to help. To speak to a securities attorney, please call our Chicago office at 312-238-9650 for a free consultation.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Ration, Florida.
To learn more about The White Law Group, visit http://www.whitesecuritieslaw.com.