Take Stock In The Futures

Betting on the future level of market indexes isn't a game for the timid. But stock futures have their conservative side as well.

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Because trading in commodities has justifiably earned the reputation of being a risky pastime meant only for the steely hearted, most stock market investors have wisely steered clear of it. But this year witnessed the birth of a stimulating hybrid -- stock market index futures -- that straddles both spheres. Index futures can be a spectacularly cheap way of wringing maximum capital gains out of stock market moves and can also be used as a short-term insurance policy to protect positions in equities or in naked options.

Stock market futures are simply commodities contracts. The "goods" that they promise to deliver on a specified settlement date are certain stock market averages. Any futures contract is a clever device that the capitalist system has devised to help pin down inventory costs and sales prices using a competitive free market. What is most clever about it -- and perhaps the hardest concept to grasp for investors used to owning a tangible share of something -- is that there can be an infinite number of contracts based on a fixed amount of supply. Generally speaking, only 1% or 2% of futures contracts involve the actual transfer of goods; the rest are financially settled without being consummated.

In this manner, risk is transferred to speculators. As anathema as speculation may seem in a commercial arrangement that literally provides such everyday necessities as meat and potatoes, speculators, by being willing to take the other side of a "bet" on where actual future prices will be at a certain date, in fact contribute to what has become a remarkably fair, orderly, and liquid auction market driven entirely by the forces of supply and demand. That, in a coffee bean, is the basis of the market in which futures are now emerging.

What took stock futures so long to find a place among the hogs, wheat, copper, world currencies, Treasury bills, and other by-now-familiar commodities was that they are a totally abstract notion.Unlike other futures contracts (except those for Eurodollars), which ultimately yield a given commodity, stock market index futures never do. At the contract's settlement date, the stocks involved in the index that underlies the contract are not parceled out like eggs or pork bellies. That would be next to impossible. Of the three different futures being offered as of this writing (two other variations are in litigation), one is pegged to the Standard & Poor 500 Composite Index, another to all 1,500 or so of the common stocks of the New York Stock Exchange Composite Index, and the third to the nearly 1,700 stocks that make up the Value Line Composite Average as compiled by Arnold Bernhard & Co. Even if a clearinghouse undertook to deliver proportionately the stocks involved, shaving off the correct fractions would be all the more difficult with the first two, in that they are "weighted" averages, with a stock's capitalization determining its relative influence on the statistical calculation.

Instead of potentially delivering shares, all stock market index contracts simply expire. Accounts are evened on the last day, according to where the underlying index stands. If you are behind, you pay the clearinghouse; it pays you if you are owed. Then, as on a Vegas roulette table, the chips are cleared off the felt and a new contract is begun for future "delivery" 12 or 18 months hence. (Index futures are written in quarterly intervals.) Because there are no actual goods involved, rank speculators are deprived of the opportunity to execute one of commodity trading's more unsavory tactics -- the "squeeze," or "corner." In this bold maneuver, speculators scheme to take delivery of much of the limited supply of the commodity, thus controlling, as Bunker Hunt did with silver in 1979, its availability and price on the open market.

Another commoditylike characteristic of index futures comes in the type of brokerage account that must be set up. A commodities player has to meet minimum net worth and liquidity standards -- usually $75,000 and $20,000, respectively. Then, to buy or sell short a contract, margin must be put into the account.

Unlike margin in an equities account, the brokerage firm does not lend the customer the rest of the money; hence no interest is charged. Commodities margin is really a good-faith deposit. It can be made up of Treasury bills or money market funds, so that the deposit can continue to earn interest even while it is serving to take a futures position. Margin on stock market futures is around 10% of the value of the contract for speculators (defined as traders who don't have stock portfolios adding up to the value of the contract) and 5% for hedgers (those who do). Like other commodities, an index future is "marked to the market" each day. If there is a gain for the day, the customer can pocket it if he or she wishes; if there is a loss for the day, it is taken out of the account and sent to the exchange. If the losses bring the account below a certain maintenance level (usually $2,000), more money must be coughed up.

The first-ever stock index futures contract was introduced to public trading by the Kansas City Board of Trade on February 24, 1982. Contracts written through the KCBT have the Value Line average as their underlying commodity, with spot values 500 times the VLA. When the VLA index is at, say, 120, the spot contract is worth $60,000. Price increments are five basis points -- 0.05 in the VLA, or $25. At this writing, margin is $6,500 for speculators and $3,250 for hedgers.

Coincidentally, the comparative arithmetic for the other two works out in neat harmony. The Chicago Mercantile Exchange uses the S&P 500, which happens to be roughly at the same level as the VLA. Its contracts, too, are worth 500 times the index, and margin requirements are similar. The New York Futures Exchange (NYFE -- pronounced "knife") is predicated on the NYSE Composite, which is approximately half the other two; at 500 times the NYSE, two NYFEs are worth about one of the others.

Two more kinds of contracts readied for trading at still other exchanges ran into litigation that held them up. New York's Commodity Exchange Inc. (COMEX) attempted to attach itself also to Standard & Poor's, but was cited for copyright infringement by S&P. And the Chicago Board of Trade devised a parcel of contracts essentially using Dow Jones calculations. Dow Jones filed suit, however, feeling that it had the responsibility to ensure that its name or products not be connected with a speculative trading device.

Although they are not subject to surprise freezes as are, say, orange juice futures, index contracts are as volatile as commodities and must be treated with equal care. You can make a lot of money in a hurry, to be sure, but by the same token the person on the other side of the contract is losing it just as fast -- and that could as easily have been you. If the NYSE drops 100 basis points -- from 63.50, perhaps, to 62.50 -- the holder of the contract has lost $500. Since he has put up only $3,500, that is a hefty 14%. And stocks are capable of dropping that much in a matter of hours.

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