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The Future Of Stock Trading
by Bill Johnson, Options Strategist
Most investors have heard about futures contracts but few can tell you what they are. The reason most investors do not know more about them is because the only thing they've ever heard is that futures are incredibly risky; that you can lose your entire investment in the blink of an eye; and that futures are really only suited for out-of-control speculators. If this were true, the question of why anybody would bother to learn about futures is a good one.
But a better question is why do futures still exist? If it were true that the futures markets are just legalized gambling, and futures investors always end up losing money, then why have they persisted for so long? Why do investors use futures?
The reason it may seem contradictory that many of the world's best investors use futures markets - despite the perceived risk - is that you're only hearing part of the story. Any asset can be risky if used the wrong way and futures markets are no exception. Credit cards are a good example: They can get you into serious trouble and also be a lifesaver with equal ease; it all depends on how they are used.
In 1995, Nick Leeson single-handedly bankrupted Baring's Bank, one of the world's largest banks at the time, by creating a $1.3 billion loss using futures markets to speculate on the direction of the market. In June 2002, John Rusnak, a currency trader for Allfirst Bank, scored a $691 million loss using options on futures. It is easy to hear these sensational stories and think we should do away with futures markets.
However, at the time of these bank catastrophes, Kellogg cereal, Coca-Cola, Ford Motor Company, and nearly any other major company you can think of also used futures contracts. But rather than speculating on currencies or the direction of the stock market, they used them to lock in profits and remove unwanted risk from their production. In doing so, they also created lower and more stable prices for all countries in which they conduct business. We would live in a very different world if futures contracts did not exist. Are futures contracts good or bad? It all depends on how they are used.
The fact is that futures markets are the most cash-efficient way to invest, which is a benefit the professionals have enjoyed for years. Futures also provide greater portfolio diversification, custom tailored assets, quicker executions, and are even exempt from the "uptick" rule if you wish to "go short" making them a truly flexible and powerful asset that cannot be matched, in many respects, by any other.
The benefits of futures contracts have recently been brought to the stock market in the form of single-stock futures contracts. You can now trade futures contracts on your favorite stocks such as Microsoft, Intel, and numerous others.
So just what are the benefits? For starters, there is tremendous leverage. Single-stock futures only require a 20% initial margin requirement as opposed to the 50% Reg-T of the stock market. That means less money invested for the same dollar-for-dollar move you get in the stock. Single-stock futures provide a way to diversify your portfolio by allowing a greater selection of stocks for a given dollar amount to invest.
Second, there is no uptick rule if you wish to sell short. If you wish to short a stock, you must first get approval from the broker's stock loan department and wait for an uptick. That can take several minutes, which seems like an eternity if you are actively trading. Single-stock futures are far more maneuverable. You can move from long to short in an instant, thus capturing a greater number of trades as well as a greater portion of the move.
Third, futures are more cash-efficient than stock. If you buy a stock for $100 and it is later trading for $103, you have an unrealized profit of $3 per share. In order to get the profit, however, you must sell your shares. Of course, if you sell your shares, you then forfeit any further profits from the position. It's a dilemma that traders face every day. But with single-stock futures, you stay in the position - and you get the cash.
EDITOR'S NOTE: For those of you who live in South Florida, Bill will discuss the many other benefits of single-stock futures at the USIC meetings on March 3, 4, 5 & 6. If you attend, you will gain a knowledge that will greatly change the way you invest. Even if you have no plans to invest in this vehicle, you need to know about it, because single-stock futures are destined to have a great impact on the stock and options markets. I hope to see you there! If you would like to have Bill speak at your Club, please contact him at BJohnson@21stCenturyInvestor.com.
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