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April 21, 2005

Back to the Stock Futures? Educating the Short Sellers and the Professional Traders

By Mark Longo

Still, despite the regulatory problems, these products have much to offer both retail and institutional equity traders. Thanks to single stock futures, traders can finally circumvent the old equity limitations. One example is the uptick rule. It has been the bane of many prominent traders over the years.

Final Nail

Single stock futures were seen as the final nail in the coffin of this age-old problem. Traders would no longer be forced to watch their stock plummet without any hope of salvation. Instead, they could sell futures against their equity positions. That's provided they understand these exotic instruments.

"People just don't realize the intrinsic benefits of these products, such as margin benefits and selling on a down tick. For a retail customer, these are gigantic benefits. On the other hand, institutional customers can use these products as a vehicle to avoid interest rate risk," says CBOE's Esposito.

Cost could also be another selling point of this product. It is cheaper to own a futures position than it is to own the stock itself. This is because futures don't have the same carrying costs as equities. An equity trader has to finance large positions when buying and selling the underlying stock. By contrast, he only has to put up a small margin payment when purchasing a futures contract.

You'd think that this drastic price difference would be enough to motivate traders to abandon their equity positions and embrace futures. However, this distinction appears to be lost on many equity traders. "Our big initiative in single stock futures right now is to appeal to experienced traders," says Brodsky. "We're trying to teach them that they can trade Intel, for example, and not have the cost and interest rate risk of borrowing the stock."

While they are simple and cheap, the people who are most excited about these products are short sellers. Lack of short liquidity is a well-known problem in the equity industry. In some equity products, traders have to struggle to borrow even a handful of shares. Even in liquid products, short squeezes and other factors can drive up short interest rates to crippling levels. Single stock futures were designed to beat shortages. Instead of having to scramble to borrow the stock, traders could save time and money by shorting the futures. That was the theory. However, the theory and practice have been different. In reality, futures market makers encountered the same problems borrowing stock as everyone else. The futures markets widened out to reflect this lack of liquidity. Market makers, an industry executive explains, have been targeted, as potential big buyers of single stock futures.

Market Makers

"One of the key selling points for these products was that they would make it easier for market makers to hedge their positions in products where it is difficult to borrow stock," says Ed Boyle, vice president of equity derivatives at TD Securities. "Unfortunately, that hasn't turned out to be the case."

Wide markets in certain illiquid products is a problem. Still, it isn't the chief hurdle facing single stock futures. If these products are going to survive another year, then they must overcome the inherent resistance of the brokerage and clearing firms.