Single-Stock Futures Part 4

Single-Stock Futures

Now that you have a basic understanding of futures contracts, you should be able to see their advantages and hopefully have a strong interest in finding out more. As mentioned during the first course section, most investors have had little to no interest in futures since they think they are normally traded on commodities (even though the majority is on financial futures). But the creation of single-stock futures will change the way investors feel about them. Once they start trading, there will be no need to learn the futures market by buying and selling pork bellies, cocoa, or benzene. You can buy and sell contracts on the stocks you know and understand with the same benefits that commodity futures traders have had for years.

If single-stock futures are such a great idea, why did it take so long for idea to catch on?

The Shad-Johnson Accord

Actually, it didn't take long to catch on. It just took a long time to get the idea passed due to political control reasons. Stock index futures began trading at the Chicago Mercantile Exchange in 1982, which included the popular S&P 500 index contract (Standard & Poor's 500). It was at this time that single-stock futures and narrow based indices were also being considered but stalled over concerns of which regulatory body would control them. Should these contracts be regulated through the Securities Exchange Commission (SEC), who controls the equity markets or should it be controlled through the Commodities Futures Trading Commission (CFTC), which is the governing body of the futures markets?

The debates became heated and drawn out between SEC Chairman John Shad and CFTC Chairman Phil Johnson until Congress suspended the idea of single-stock futures so as not to hold up the index futures through a bill known as the Shad-Johnson Accord.

Commodities Futures Modernization Act (CFMA)

In December 1999, various Congressional committees pushed for a plan, which would lift the nearly 20-year ban on single-stock futures. The result was the Commodities Futures Modernization Act (CFMA) and was signed into law one year later by President Clinton. The trading of these assets was scheduled for September 2001, but the terrorist attacks on the U.S. delayed their introduction. We can expect to see single-stock futures trading in the U.S. by the end of 2002. The current stalls are now coming from rulings on initial margin and maintenance requirements (which we'll talk about later in this course) as well as taxation rulings from the Internal Revenue Service.

It was critical for the CFMA to be passed as single-stock futures were already trading in Europe through contracts known as Universal Stock Futures, which started in January 2001 on the London International Financial Futures and Options Exchange (LIFFE). These universal stock futures were quickly gaining popularity -- 20 of which were U.S. companies -- and there was fear that the European exchanges would control the trading of these viable assets. The U.S. wanted to remain the leader in financial markets and had to pass the CFMA in order to not lose this business to overseas markets.

New Products Form New Exchanges -- OneChicago and Nasdaq-Liffe

Brand-new electronic futures exchanges will be created to trade this hybrid stock and futures product. Technically, any exchange can file to trade these products but, as of now, there are two that will begin trading single-stock futures immediately: OneChicago and Nasdaq-Liffe Markets (NQLX).

OneChicago is comprised of the three largest exchanges in the world for futures and options -- the CME (Chicago Mercantile Exchange, CBOT (Chicago Board of Trade See CBOT) and CBOE (Chicago Board Options Exchange).

On the Nasdaq-Liffe (pronounced LIFE) exchange, the LIFFE brings a lot of experience to the partnership with its LIFFE CONNECT ^TM trading system, which is the world's most advanced electronic derivatives trading platform already capable of handling large order flow while the Nasdaq will blend its state-of-the-art technologies to make single-stock futures as well as narrow-based indices (collectively called single futures products, or SFPs) and provide a highly efficient platform to trade these exciting new products.

Using the Web
You may wish to go to the following links and find out more about OneChicago and Nasdaq-Liffe exchanges. This is where you can get information on their products, such as narrow-based indices, as well as quotes on single-stock futures. It will be important to know how to navigate through them!

http://www.onechicago.com/

http://www.nqlx.com/

The First Wave

Any time a significant change is made in the securities markets, the regulators always manage the change slowly just in case there are any bugs in the system. Typically they move the companies over in blocks of 50, which is what happened with when the industry moved to after-hours trading and decimalization. The same process will be used with single-stock futures and the first 50 companies expected to begin trading are a mixture between those listed on the New York Stock Exchange (NYSE) or traded on the Nasdaq:

Nasdaq Liffe Markets Initial Stock Listing (as of February 1, 2002)*

Stock	Symbol	GICS Group	Exchange
Advanced Micro Devices	AMD	Semiconductor Equipment & Products	NYSE
American International Group	AIG	Insurance	NYSE
Amgen Inc	AMGN	Biotechnology	Nasdaq
AOL Time Warner	AOL	Media	NYSE
Applied Materials	AMAT	Semiconductor Equipment & Products	Nasdaq
AT&T Corp	T	Diversified Telecommunications Services	NYSE
Bank of America Corp	BAC	Diversified Financial	NYSE
Bristol-Myers Squibb	BMY	Pharmaceuticals	NYSE
Brocade Communications System	BRCD	Communications Equipment	Nasdaq
ChevronTexaco	CVX	Oil & Gas	NYSE
CIENA Corp	CIEN	Communications Equipment	Nasdaq
Cisco Systems Inc	CSCO	Communications Equipment	Nasdaq
Citigroup Inc	C	Diversified Financial	NYSE
Coca Cola Co	KO	Beverages	NYSE
Compaq Computer Corp	CPQ	Computers & Peripherals	NYSE
Dell Computer Corp	DELL	Computers & Peripherals	Nasdaq
eBay	EBAY	Internet & Catalogue	Nasdaq
EMC Corp/Massachusetts	EMC	Computer - Peripherals	NYSE
Exxon Mobil	XOM	Oil & Gas	NYSE
Ford Motor	F	Automobiles	NYSE
General Electric	GE	Industrial Conglomerate	NYSE
General Motors	GM	Automobiles	NYSE
Genzyme Corp-General Division	GENZ	Biotechnology	Nasdaq
Home Depot	HD	Specialty Retail	NYSE
Honeywell International Inc	HON	Aerospace & Defense	NYSE
International Business Machines Corp	IBM	Computers & Peripherals	NYSE
IntelCorp	INTC	Semiconductor Equipment & Products	Nasdaq
Johnson & Johnson	JNJ	Pharmaceuticals	NYSE
JP Morgan Chase & Co	JPM	Diversified Financial	NYSE
Juniper Networks Inc	JNPR	Communication Equipment	Nasdaq
Merck	MRK	Pharmaceuticals	NYSE
Merrill Lynch & Co Inc	MER	Diversified Financial	NYSE
Micron Technology Inc	MU	Semiconductor Equipment & Products	NYSE
Microsoft Corp	MSFT	Software	Nasdaq
Morgan Stanley Dean Witter & Co	MWD	Diversified Financial	NYSE
Nokia OYJ	NOK	Communications Equipment	NYSE
Oracle Corp	ORCL	Software	Nasdaq
PepsiCo Inc	PEP	Beverages	NYSE
Pfizer Inc	PFE	Pharmaceuticals	NYSE
Procter & Gamble	PG	Household Products	NYSE
Qualcomm Inc	QCOM	Communications Equipment	Nasdaq
SBC Communications Inc	SBC	Diversified Telecommunications Services	NYSE
Siebel Systems Inc	SEBL	Software	Nasdaq
Sun Microsystems Inc	SUNW	Computers & Peripherals	Nasdaq
Texas Instruments Inc	TXN	Semiconductor Equipment & Products	Nasdaq
Veritas Software Corp	VRTS	Software	NYSE
Verizon Communications Inc	VZ	Diversified Telecommunications Services	NYSE
Wal-Mart Stores Inc	WMT	Multiline Retail	NYSE
Walt Disney Company	DIS	Media	NYSE
WorldCom Inc - WorldCom Group	WCOM	Diversified Telecommunications Services	Nasdaq

Mechanics of Single-Stock Futures

It's now time to get into the details of how single-stock futures work. We're going to start from a broad level and then work down to specifics, such as how to read quotes and actually monitor a hypothetical trade.

The mechanics of buying and selling a futures contract is very similar to stock. As we said in the previous lessons, if you buy the futures contract, you want the price to move higher. If you short (sell) the futures contract, you want the price to fall. From a profit and loss standpoint, a long futures position looks just like a long stock position as shown in the following chart:

Compare this to a long $50 call optionin the next chart below. We can see that call optionsprovide an asymmetrical payoff meaning that profit and losses do not occur in a straight line over all stock prices. We also said earlier in the course that long futures contracts behave like long deep-in-the-money call options. You can see from the next chart that this would be true for all stock prices above $50 at expiration; that is the portion of the call option payoff that is a straight line. Whether the stock rises or falls in this range, the long call owner will gain or lose point for point just as a long as the futures holder would. However, if the stock falls below $50, the call option owner limits the losses. While limited losses are a big advantage of options, keep in mind there is no time premiumpaid, other than the cost of carry, for the futures position. The value of the long futures contract will not decay from the passage of time as a long call option would.

This emphasizes the fact that futures are not options and the reason why should now be much clearer. They offer very different risk profiles. Futures are much more like stock even though they are a derivative.

Single-stock futures are not too hard to understand. However, there is a lot of terminology that is new, so we're going to take it slow so you understand all the necessary components. We'll start with some basic definitions and examples and then put it all together at the end with a single-stock futures trade from the beginning. So as you read the following paragraphs, please don't be alarmed if you're feeling lost -- it will all come together in the end. Just try to understand each section and then move on to the next.

How Big Is the Contract?

The first thing you must understand about any futures contract is that it is a contract to either buy or sell a specific amount of the underlying asset. Each single-stock futures contract will control 100 shares of stock. Therefore, if you buy 3 futures contracts, you're really agreeing to buy 300 shares of the underlying stock some time in the future. If you sell 5 futures contracts, you're agreeing to sell 500 shares of stock some time in the future.

The total contract value is the price of the contract multiplied by the number of units of the underlying. If you buy 3 contracts at a price of $50, you're agreeing to buy 300 shares at $50, which is a total contract value of $15,000. It is important to know the total contract value, as that will determine how much money you need to deposit with your broker.

Initial Margin

If you enter a futures contract, you are only required to deposit a small amount of money with your broker. This is true whether you are the buyer or the seller of the contract! If you are familiar with options, this will seem unusual as option sellers are used to receiving money for entering the contract. Remember, futures are not options and there are no "time premiums" above the cost of carry. Buyers and sellers of futures contracts deposit the same amount of money (assuming all else remains constant) with their brokers.

The amount you must deposit is known as initial margin (also called a performance bond, which at the time of this writing is proposed to be 20% for single-stock futures. If you buy (or sell) 3 futures contracts at $50, you would be required to deposit 300 * $50 * 20% = $3,000.

The fact that you only deposit a small amount of money is one of the biggest benefits of futures; you can control a large number of shares for very little down. Before you get too excited, you need to understand that whenever you pay a fraction of the total purchase price, you gain financial leverage and the leverage can hurt you just as easily as it can help. This is true for any asset -- not just futures. One of the simplest examples is the purchase of a home with a mortgage. Assume you buy a $100,000 house and pay for it in full. If prices rise to $110,000 and you sell, you made 10% on your investment. Now consider what happens if you put $10,000 down and borrow the remainder. If prices rise to $110,000, you could sell it and pay off the $90,000 mortgage and be left with $20,000. Now you made $10,000 for only $10,000 down, which is a 100% return on your investment. Note the mathematical relationship with the leverage, too. The reason you are up 10 times the amount on a percentage basis (100% versus 10%) is because you only put 1/10 of the amount down. Once again, it is this fractional payment that allows greater magnification of your returns.

Notice how this leverage works in the other direction too. If the price of the house falls to $90,000, the person who pays in full is only down 10%, while the person who puts down $10,000 loses 100%.

Because single-stock futures are expected to require 20% initial margin (1/5 of the total contract value), they will provide five times the leverage of stock purchased in full. This 20% figure is just a guideline for several reasons. First, as with stocks, individual firms are allowed to make stricter requirements so they could certainly make the requirements higher than that determined by the exchange. Second, as fluctuations in the underlying stock rise and fall, the exchanges can, and do, alter the requirements to keep the margin in line with the current volatility. Third, margin requirements for futures often depend on the objectives of the trader, too. If you are a retail customer making a speculative trade, your requirements will likely be higher than that of a bona fide hedger, such as a large corporation selling futures against anticipated delivery of the underlying asset.

Currently, you can get leverage in the stock market by purchasing on margin. The initial margin rates for the stock market (know as the Reg T amount) are 50%. For example, you could buy 300 shares at $50 and are only required to pay $7,500 -- half the amount -- and can borrow the remainder from your brokerage firm, provided that you filled out the necessary margin account agreement. If you buy stock on margin, you gain two times the leverage of stock purchased in full. As you can see, futures markets allow far greater leverage than the stock market.

Leverage can be your best friend and is the one variable that has been key to many great success stories in the market. However, it can also be your worst nightmare and is the same variable that has destroyed many speculators and even corporations. Nick Leeson destroyed the historic Baring's Bank by recklessly speculating in the futures market in an attempt to support some options positions that had already gone bad. If the leverage is great enough, even well capitalized banks cannot withstand the pressures.

With a 20% initial margin requirement, the futures contracts are providing a five-fold multiplier to the gains and losses in the underlying stock. It's sometimes difficult to understand this multiplier effect, but it's always there. Those who do not understand the concept of leverage with investments eventually learn the hard way. Make sure you understand just how much leverage you're dealing with before you enter into a contract and buy or sell the appropriate number of contracts you are comfortable with -- especially if you are speculating!

Key Points

• The total contract value equals the price multiplied by size of the contract
• The initial margin for single-stock futures is expected to be 20%
• Single-stock futures provide five times the leverage of stock purchased in full

Marking to Market

Notice in the above examples that we have assumed a futures price of $50. Once again, this is the amount you are agreeing to either buy or sell for in the futures. However, you not pay $50 now. So why must you pay anything? Why must you put down 20%? The reason is that, due to the extreme leverage (controlling a lot of shares for only a little money down), losses can quickly mount. In order to keep the rock-solid credit worthiness of the futures markets, the exchanges credit your account with any gains and debit your account for any losses on a daily basis. This is done at the end of the first day you enter the trade and at the close of each trading day thereafter. This process is known as marking to market -- the account is being marked to the market price of the underlying asset. The initial deposit is sometimes referred to as a "good faith" deposit, which is a way to show that you intend to buy the underlying asset, which is similar to why stores charge a small amount to purchase something on a layaway plan. However, unlike layaways, the initial margin deposit is not a down payment on the underlying stock.

The reason it is not a down payment is because you still owe the total contract value at expiration. For example, if you buy one futures contract at $50, that's a total contract value of $5,000 and you would be required to put down $1,000 as initial margin. However, at expiration, you would be required to pay $5,000 to take delivery of the underlying stock and not the difference of $4,000. Assuming the underlying stock has moved in your favor, that initial $1,000 will still be in your account. However, if it moves against you and you still decide to take delivery, do not think that the initial deposit offsets the amount you owe. Once again, the initial margin deposit acts as a way to secure the credit of the futures market. This is a confusing topic, so let's use an example to help you understand.

Example:
Assume you buy five contracts at a price of $50. The total contract value is $25,000 and your initial margin is $5,000. Now assume that the futures contract closes at $51 the same day that you purchased it. If so, your account will be credited with the net change (+$1) multiplied by the number of shares you are controlling, which is 500 in this example. The futures contract rose by $1, so your "500 shares" have increased in value by $500. Your broker will credit your account $500 cash that evening. The person on the other side of the trade, the short seller of the contract, will be debited $500 that evening as well. The losses to the "losers" are transferred to the "winners" at the end of each trading day.

This cash is available for immediate withdrawal if you choose. However, most investors leave it in the account in the event they are on the "losing" side one day; it serves as a source of funds for potential debits.

Futures Positions Are More Cash Efficient

We said in the introduction that futures are the most cash-efficient way to trade. Now the meaning behind that statement should be more apparent. Let's say that, instead of buying five futures contracts, you purchased 500 shares of stock at $50. If the stock is trading at $51 at the end of the day, your position is worth an additional $500 -- if you sell. But if you sell, then you run the risk of further upside potential. It becomes a tough game and is probably the biggest source of frustration among stock investors. With futures though, you get cash credited to your account (assuming it moved in your favor) that you can access without having to close your position.

Special Note: I know some of you may be thinking that you can access the cash immediately in a stock account through your "margin cash" which increases as the stock price increases. That's partially true. I don't want to turn this into a margins course but, at the same time, I don't want those who understand SMA (Special Memorandum Account) and margin cash to think that they're being misled. You can withdraw excess cash from stock increases but only if it rises above the 50% mark. If it falls below that and then rises, you will not get the gains until it passes the 50% mark, which is not the case for futures. Futures truly are more cash efficien

Thought Questions: If you are only required to pay a fraction of the total purchase price and your account is debited or credited daily, do you think it is possible to continually be debited? How do you think the brokerage firms make sure that you will, in fact, have enough money to meet your future obligation?

Maintenance Margin

The brokerage firms usually allow for minor fluctuations and will permit your account to lose some value before requiring you to bring in more money. That level is called maintenance marginand, if reached, you will be required to bring your account back up to initial margin levels. The maintenance margin levels vary but are typically about 20% to 25% below the initial margin levels. There is some talk, however, that the initial margin levels and maintenance margin levels may be the same amounts for single-stock futures.

For example, say you entered three contracts at $50 and paid $3,000 initial margin. If the exchanges allow single-stock futures to have a maintenance level, it would probably be 20% below that $3,000 amount, or $2,400. Assume that the next day the futures contract is trading for $48.50, down $1.50. As we learned in the previous section, your account would be debited -$1.50 * 300 = $450. Your account was worth $3,000 but is now only worth $2,550. For the moment, your account is still in good standing since it is above the maintenance level of $2,400. However, let's assume that the futures contract closes down $1 the next day at $47.50. Your account is again debited -$1 * 300 = $300 and is now worth $2,250, which is below the maintenance level of $2,400. You will receive a phone call from your broker stating that you need to send in money known as variation margin of $750, which will bring your account back up to the initial margin level of $3,000.

Also note that it is critical to understand where the maintenance levels are and how it would affect you if they were hit. The reason why is that it is possible to have to send in a great deal of money when there is only a slight move against you. For example, say you purchased 10 contracts at $50. Your initial margin is $10,000 and your maintenance would be $8,000 (assuming maintenance levels are 20% below initial margin). You deposit $10,000 with your firm only to find the futures position going against you. Day after day it falls but with no phone calls from your broker. One day the futures contract closes at $48, which puts your account right on the edge with $8,000 equity. The following day, you see that the futures contract closed down 1 cent. You think that 1 cent is certainly not a big deal and you must be safe for now. But then you get the call from your broker saying you need to send in $2,000! That's correct -- at one moment there's no maintenance call, and then one cent later there is. Once again, you should be very aware of where those points are and how much money you may need to send. Always check with your broker if you're unsure. This is especially important since brokerage firms are allowed to make requirements stricter. If the exchanges say that maintenance margin is 20% below the initial margin, a brokerage firm can have a policy that makes it 15% below, which is stricter.

Key Points

• Your futures account is credited or debited daily. Only if the futures contract closes "unchanged" will there be no debits or credits.
• If your account is debited significantly, it may fall below maintenance margin and you will be required to send in a check.

Futures and Forwards Revisited

Forward agreements, as we said earlier, are independent agreements between two people to buy and sell an asset for a fixed price in the future. In the case of forwards, profits and losses are not realized until that future date.

The only thing that matters to a forward contract is where it ends up at expiration. This is one of the big dangers of forward contracts, especially if the integrity of the other party is questionable. If the forward contract moves against them substantially, all of the losses are due at expiration and it is possible they may default on the agreement.

Futures contracts, however, realize profits and losses daily through the process of marking to market. In effect, futures contracts are closed and rewritten at a new price each day. With futures contracts, price swings would cause intermediate gains or losses.

As an example, we'll use the previous trade of 3 futures contracts purchased at $50. We're also going to assume the futures contract only has three price changes before expiration. First, it falls to $48, then rises to $52, then rises again to $55 and then expires. If that's the case, the following table shows the differences between a forward and a futures contract under the same terms:

	$50 Forward Account Value	$50 Futures Account Value
Initial Deposit	$3,000	$3,000
Price	Change in account value
$48	No change	- $600
$52	No change	+$1,200
$55	No change	+$900
Contract expires	+$1,500	+$1,500

To understand the table we know that the initial deposit will be 300 shares * $50 = $15,000 total contract value. Our 20% initial margin deposit will be $3,000. If the contract falls from $50 to $48 the next day, the forward contract is unchanged and no debits or credits apply. With the futures contract, a $2 loss on 300 shares, or $600, is debited from the account of the long position. If the futures closes up 4 points to $52 the following day then $4 * 300 shares = $1,200 will be credited to the long futures account. Once again, there will be no change for the forward.

At expiration, the contract value has risen from $50 to $55, which is 5 points on 300 shares, or a gain of $1,500 to the long forward position. The futures account holder has the following debits and credits: -$600 + $1,200 + $900 = $1,500. Either contract finishes with exactly the same value. The difference is that the standardized futures contract has much less risk of default since the losses are settled daily. If the short position, in this example, was at risk of default, it will show up long before expiration and helps to maintain the integrity of the futures markets.

Marking to Market Is Based on Settlement Prices

At the end of each day, your account is debited or credited based on the change in settlement prices. The only exception to this is the first day you enter the contract, in which case it's based on the purchase or sales price. We'll talk more about settlement prices shortly but, for now, just think of a settlement price as a closing price, which is what you're probably familiar with in the stock and options markets.

If a futures contract settles at $50 one day and at $49 the next, then that is a decrease of $1 in value. If you are long 3 contracts, you will be debited $300; if you are short three contracts, you will be credited $300. Once that happens, your contract is effectively closed out and rewritten at the new settlement price.

This is important to understand, since many who are new to futures think that the debits and credit are in relation to your contract price. For example, say you purchased a contract at $50 and it is now $52. The next day it is down 2 points and trading for $50, which is the same as your purchase price. Many think that there will be no debits or credits in this case since the closing price is the same as the contract price. This is not correct. Your account is always marked to market based on the settlement prices from day to day. Once again, the only exception is on the first day. You will be marked to market on the first day, but that debit or credit will be based on your purchase price and the settlement price. Every day thereafter, you will be marked to market based on settlement prices.

The reason you are marked based on settlement prices (and not contract price) is because marking to market effectively rewrites the contract price by either debiting or crediting your account. For example, if you bought the 3 futures contracts for $50 and they close at $53 the next day, you'd be up $3 * 300 = $900. But say they close down $2 at $51 the following day. Again, many incorrectly think they will be credited $1 * 300 = $300 since they are under contract at $50 and the futures closed at $51. The reason that's wrong is because the investor effectively rewrote the contract at $53 when they accepted the $900 credit the first day. If you're still not sure, think about what would happen if the futures closed back at $50 on the second day. Do you think it's fair to say that because there's no change between the closing price and your contract price, your account is left unchanged, yet you get to keep the $900 from the first day? If your contract price is $50 and the futures close at $50, your account should be unchanged in total equity. The only way to make that happen is to say your account is down $3 (from settlement prices of $53 to $50) and you should be debited $900, leaving your equity unchanged.

Marking to market allows traders to effectively close out positions and rewrite new contracts on a daily basis without having to do so. It is a procedure that allows gains and losses to mount on a daily basis rather than having to wait until expiration. This is truly an advantage of using standardized contracts by marking them to market on a daily basis. It keeps losses from continuing to mount all the way through expiration and discovers those who are risk of default in the early stages.

Key Points

Marking to marketis the mathematical equivalent of closing the existing contract and rewriting a new one at the spot price on a daily basis. The contracts are not actually closed and rewritten, but they are on a conceptual basis. If you wish to close out a contract, you must enter an order for the offsetting contract.

Which Contracts Will Be Traded?

Just as with options, futures only provide for a limited number of expiration months at any given time, which is yet another disadvantage of standardized contracts. Regardless, there are usually enough expiration months to satisfy most investors. Remember, the exchange is out to make a profit; and if a lot of people are requesting additional months, they will certainly change the rules and issue new months. So despite the limited number, you probably won't feel restricted.

Single-stock futures contracts will be available with expirations for the first five calendar quarters (March, June, September, December) and in the first two non-quarter calendar months for a total of seven months. For example, if it were now June, contracts would be available for June and July -- the current month (also called the spot month) and the following month. In addition, there would be September and December of the same year and March, June, and September of the following year. This method ensures that there will always be the first three months traded at any given time. So for now, you'll be able to take positions in single-stock futures up to 15 months away; this will likely change as their popularity grows.

Size and Expiration of Contracts

Just like equity options, one single-stock futures contract will control 100 shares of stock and will trade through the third Friday of the expiration month. If you purchase a May contract, for example, it will trade through the third Friday of that month.

Daily Price Limits

Even with marking to market, traders can get into large losses. To decrease the chances of that happening, most futures contracts have daily price limits. This simply means that the underlying assets are allowed to only move up or down a certain amount per day before trading must be suspended, and no trading can take place outside these limits on that day.

Daily price limits are normally set by the exchanges and can, under certain circumstances, be modified. For example, at the CBOT, corn futures are quoted in cents and quarter cents per bushel and have daily price limits of 20 cents per bushel with no limit for the spot month (current month contract). If corn closed at 2.201 per bushel yesterday, the highest it could trade today would be 2.40 and the lowest it could trade would be 2.00. If corn closes at 2.10 today, the new limits of 1.90 and 2.30 apply tomorrow.

It just so happens that if each corn contract controls 5,000 bushels, the most you can gain or lose in a single day is 0.20 * 5,000 = $1,000. Most commodity futures contracts have daily price limits of some type and they vary in size based on volatility and size of the contract. Many futures contracts, however, do not have daily price limits -- especially with the financial contracts, such as bond or Fed funds futures.

If a contract trades at its upper limit, it is said to be limit upor locked limit, emphasizing that trading is locked for the day. Likewise, if it reaches its lower limit, that contract is said to be limit down or locked limit down. The unnerving part about lock limit trading is that it can continue day after day, thus never allowing you a way out of the trade! So while the limits theoretically make it less risky, the reality is that you can still get stuck if a commodity decides to run away in price. For example, suppose that a commodity is trading at its upper limit and you are short the contract and will have losses at the end of the day. You wish to buy back the contract (offsetting position to get out. But if it is trading limit up then that signifies that people think the price of the commodity is going to move higher yet -- and who do you suppose wants to sell? So while you may theoretically be able to buy or sell at or within the limits, the truth is you may not find someone to take the opposite side of the trade.

We'll show you later on in the course how to protect yourself if you should end up on the wrong side of a commodity trade that is locked limit up or down.

The important thing to know is that single-stock futures will not have daily price limits! So while most of your daily gains and losses are expected to be small, if you get on the wrong side of a trade where the stock makes a large move, the losses can become large -- quickly. There are certainly pros and cons to limit trading, and is a controversial topic as to whether or not limit trading is good or bad for the markets overall. Incidentally, the minimum price fluctuation for single-stock futures, called a ticksize, will be one cent per share, or $1 per contract.

1 The quote would probably appear as 2200 with the last digit representing the quarter-cents. We'll talk more about this in another section. For now, it's too confusing to use this notation while we try to understand price limits.

Key Points

Single-stock futures will not have daily price limits. This is quite different from most commodity contracts, which often limit the daily amount the futures price is allowed to move.

Trading Hours

Single-stock futures will trade between 9:30 a.m. and 4:02 p.m. Eastern Time, which are the same hours used for equity options. So while the underlying equities will stop trading at 4:00 p.m., the single-stock futures and options will continue for an additional two minutes. This may not seem like much time, but it can really help if you are trying to hedge a stock position going into the close. Many other financial futures contracts, such as the S&P 500 or Nasdaq 100, trade nearly 24 hours per day.

Delivery Process

As we've said earlier, most futures contracts are used for hedging or speculative purposes and are just closed in the open market with an offsetting position. However, if you do wish to buy or sell the actual stock, the standard trade date plus three-business day settlement (T+3) will apply. If you take delivery through a futures contract, you will be long 100 shares per contract in three business days and your account will be debited for the contract amount at that time, too.

Because single-stock futures are not currently traded, it is difficult to say exactly what the procedure will be for taking delivery. The best thing to do is check with your broker to find out what they require, then just follow their procedures. Keep in mind that you cannot take delivery as with options. If you wish to acquire the actual shares by using your futures contract, you will need to wait until the third Friday of the expiration month.

On a technical note, if you are familiar with options, you are probably used to "exercising" your call option in order to take delivery of the shares. With futures contracts you do not exercise them. Exercising an option contract implies that you willingly decided to take delivery. With futures contracts you do not have that right. If you are long a futures contract you simply do not close it out, and you will automatically take delivery.

Settlement Day and Time

In a previous section we said that settlement prices could be thought of as closing prices. It's now time to find out exactly what a settlement price is and how it differs from a closing price. All futures contracts will "settle" at 10:00 a.m.daily gains, losses, and margin requirements will be calculated based on this settlement amount. This is important to understand because the settlement price may be quite different from the last trade. on the following business day following the last trading day. What does this mean? It means that your

For example, say you are just entered a long futures contract at $50 like the one we discussed earlier. It is now the end of the trading day and the stock closed up half a point at $50.50, which you would normally assume means you made a little money. More important, you don't owe any money. However, that closing price is irrelevant in futures trading, and your gains or losses will be based on the settlement price, which is not until 10:00 a.m. the following morning.

It is possible that the stock is actually trading below that last trade at settlement time, which could bring your account below margin equity requirements. If so, you will be required to send in more money even though the underlying stock closed up.

The settlement price is determined by a settlement committee, which tries to determine the fair market value of the contract based at that time. There is usually a different settlement committee for each commodity. The proposed method for daily settlement of single-stock futures, according to the NQLX, will be as follows:

Proposed Settlement Price Calculations

The Settlement System will calculate the Daily Settlement Price based on reported prices in the two-minute period prior to the time specified for contract settlement. The first ninety seconds of the settlement period will be used to monitor spread levels. The Settlement Price will be determined during the final 30 seconds of the settlement period, according to the following criteria:
a. A single traded price during the last thirty seconds will be the Settlement Price.
b. If more than one trade occurs during the last thirty seconds of the Settlement Range , the trade-weighted average of the prices, rounded to the nearest tick, will be the Settlement Price.
c. If no trade occurs during the last thirty seconds of the Settlement Range , the price midway between the active bids and offers at the time the settlement price is calculated, rounded to the nearest tick, will be the Settlement Price.
d. In the circumstances where there is no traded price nor updated bid/ask spread during the last 30 seconds of trading, the settlement price of that contract month shall be the settlement price of the 1st quarterly delivery month plus or minus the latest observed calendar spread differential between the first quarterly delivery month and the contract month in question. In the event that the relevant spread price differential is not readily observable, in order to identify appropriate settlement prices, Exchange Market Services may take into account the following criteria as applicable 1) spread price differentials between other contract months of the same contract; and 2) price levels and/or spread price differentials in a related market.

Why do futures use a settlement committee to determine the fair market value rather than use the last trade? In most cases, the settlement price will be equal to, or at least very close to, the closing price. However, there may be times when you may be holding an illiquid futures contract (not a lot of trading or open interest) and their price may not adjust quickly to current news. It is the job of the settlement committee to ensure, to the best of their ability, that all current information is being reflected in the price of the contract.

Each contract will have a symbol that indicates the settlement price determined by the committee. For instance, if you trade S&P 500 contracts, you can usually type in the symbol "SET" on many advanced quoting systems (as you would for getting quotes on a stock) and you will get the settlement price for the current contract. Similarly, "NQS" is usually the symbol for the daily settlement price for the Nasdaq 100. You will also be able to find the settlement prices for all contracts at each exchange's Web site.

While there are pros and cons to using settlement committees, it's not really a big concern one way or another. After all, a closing price is just a snapshot in time as is a settlement price. Sometimes the settlement prices will be in your favor and other times it won't. We don't intend to debate whether this method of settlement should or should not be done. Just be aware that's how it is done.

You now have all the basics of single-stock futures! Hopefully you see, aside from some of the terminology, that they're really not too difficult to understand. We'll be going through trading examples later from start to finish that will help to solidify the concepts. For now, you may wish to review this course to make sure you understand all the concepts we've discussed. In the next course, we're going to go through a futures contract with a commodity. Why will we be discussing commodities? First, it aid in your general understanding of futures contracts, and there are also some quirks among commodities you need to be aware of just in case you decide to trade them. Believe me, once you get hooked on single-stock futures, you will see many trading opportunities that are better suited for commodities and it will be important to have a basic understanding.