Money: The Futures of Stocks

One of the brighter aspects of the Reagan era has been the deregulation of financial markets. The latest manifestation of the new climate is the introduction of stock index futures to an enthusiastic market reception. Within a few months, three exchanges have launched trading in three different stock indices, allowing speculators to buy or sell the entire market rather than individual stocks and enabling investors and institutions to hedge their actual stock positions.

Predictably, many would-be regulators branded the new futures instruments as a form of "gambling" that would drain and weaken the equity market. But there is every reason to believe that stock index futures will not only be a boon to investors but will strengthen the stock market. As they mature, the index futures markets—Kansas City Board of Trade's Value Line Average (VLA) index, Chicago Mercantile Exchange's Standard & Poor's 500, and the New York Futures Exchange's New York Stock Exchange (NYSE) composite—will probably attract more and more hedging interest from individual investors, pension funds, portfolio managers, estate executors, new issue underwriters, market makers, and specialists.

As Ira Haupt, a partner in the NYSE member firm of Haupt-Andrews and trader on the New York Futures Exchange, says, "[Stock index futures are] another form of risk transfer (in addition to stock options), and the more risk transfer you have, the more valuable the underlying stock market. It increases the liquidity of the stock market."

Each stock index futures contract has a minimum price move of 5 cents, and since the value of each contract is $500 times the spot index, a minimum price move is worth $25 per contract. A full point move is worth $500 per contract. None of the markets, incidentally, have maximum ("limit") price moves, a welcome change from disruptive past practice.

At the indices' recent spot levels (132.11 for the Value Line Average of 1,685 stocks, 118.22 for Standard & Poor's 500, and 68.20 for the New York Stock Exchange composite index of 1,532 stocks), the Kansas City contract is worth $66,055; the Chicago Merc contract, $59,110; and the New York Futures contract, $34,100. Exchange minimum margins vary—from Kansas City's $6,500 to $6,000 on the Chicago Mercantile Exchange and $3,500 on the New York Futures Exchange. That works out to approximately 10 percent.

If you are of a speculative frame of mind, stock index futures are a highly leveraged way of trading the stock market. "A guy with $100,000 who wants to speculate in the stock market, instead of going to his broker and buying all these stocks, can now just buy the market," observes Dr. Wray Kunkle, manager of Richardson Securities in Washington. "Plus, he can control $1 million with $100,000." (The margin on stock purchases is 50 percent.)

The simplest stock futures plays are outright long or short positions. If you think the stock market is going to rise generally between now and the end of the year, you can go long and buy a December NYSE contract, which traded recently at 69.45. If between now and the end of December the NYSE index rises to 71.45, the two-point move is worth $1,000 per contract. If the opposite happens and the index falls two points to 67.45, you lose $1,000—unless, of course, you were short December.

Because the premiums on forward months are very small in all of the stock index futures, the market favors bulls. For longs, the smaller premiums mean greater profits and smaller losses for a given change in price. For shorts, the smaller premium means smaller profits and greater losses.

Spreads—buying or selling contracts in different months or different markets—are a less risky way of trading stock index futures. Because they tend to be less risky, they carry lower commissions and margins. The object is to gain from future changes in the differential between two contracts.

Most common are intramarket spreads. The general rule is: if the distant months seem to be rising faster than the nearby months, buy the distant months and sell the nearby. If the front months seem to be rising faster than the back months, you would do the opposite—buy the nearby and sell the distant months.

Another possibility is an intermarket spread. You might want to go long the VLA index, for instance, with its greater weighting of better-performing second-tier stocks, and short the NYSE index with its preponderance of heavily capitalized stocks. If and when indices based on industrials, utilities, transportation stocks, and so forth are approved, the possibilities widen. If you expect different trends in the stock and bond markets, you can already do a spread between one of the stock index contracts and a Treasury bond or Ginnie Mae contract.

Because no one knows where the stock market is going from day to day, or even month to month, it is best to follow a few rules. To begin with, get to know the market. Although there are as yet no charts available on these futures, it is easy enough to get charts of the actual indices. In addition, you can chart the different contract months yourself. Having done that, you can draw trend lines and trade within the channel that they form—selling at the top of the trading range and buying at the bottom. Using moving averages—watching the intersection of three different period averages to pinpoint trend changes—is more precise.

No system is perfect, so it is wise to use "stop" orders. Whether you are buying or selling, you can place a standing order with your broker to close out your position at some prudent level above (if you are short) or below (if you are long) your entry price. That limits the risk of an adverse price move.

A final word of warning: this market is not for the small investor with little financial cushion nor for the nervous. As with other "commodities," the risks of loss are as great as the profit potential. It should not be supposed that one can simply buy or sell the indices and cash in if the market moves your way. Short-term fluctuations en route to your predicted bull or bear market can wipe out your margin and more very quickly. If you can't stand large setbacks, you should look instead at stock options, where the risk is limited to a relatively small premium. Or wait for the next new wrinkle—options on stock index futures.

Steven Beckner is a free-lance financial writer, the assistant editor of World Money Analyst, and the author of The Hard Money Book.