Course #202: Single-Stock Futures

Introduction

Most investors have heard about futures contracts, but few can tell you what they are. The reason most investors know so little about them is because they’ve most likely only heard the misconception that futures are incredibly risky, that they could lose their entire investment in the blink of an eye, and that futures contracts are really only suited for out-of-control speculators. If this were true, then questioning why anybody would ever bother to learn about futures trading would seem to be valid.

But here’s a better question: Why futures contracts still exist? If it were really true that the futures markets are just legalized gambling arenas where investors are destined to lose money, then why have they persisted for so long? Why do investors use futures?

The reason it may seem contradictory for many of the world's best investors to use futures markets -- despite the publicized risk -- is that you've probably only heard part of the story. Any asset can be risky if it’s used the wrong way, and futures markets are no exception. Credit cards are a good example -- they can cause 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-dollar 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-dollar loss using options on futures. It is easy to jump to the conclusion that we should do away with futures markets after hearing sensational stories like these.

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 conducted 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 for greater portfolio diversification, custom-tailored assets, and quicker executions. They are even exempt from the "uptick" rule if you wish to "go short," which makes them a truly flexible and powerful asset that cannot be matched, in many respects, by any other.

Single-Stock Futures

Many investors avoid learning about futures contracts because they are typically traded on pork bellies, heating oil, wheat, and other commodities in which most of us have no reason, or desire, to invest. That all changed, as futures contracts on individual stocks -- single-stock futures -- have been trading since November of 2002. Rather than trading futures contracts on pork bellies, euros, or mixed xylenes, you can now trade futures contracts on individual stocks such as Intel, Microsoft or many others. While not all stocks have futures contracts on them, most of the major names you know eventually will. If you want all of the benefits the professionals have enjoyed for years and you are an avid investor or speculator, it will pay to understand futures.

This course will take you by the hand from the very beginning. We will give you simple examples of futures contracts, work up to real commodity contracts, and then bring you up to speed with single-stock futures. You'll understand everything you need to know to be comfortable placing your first trade.

For now we just ask that you forget about every negative thing you may have heard about futures and approach this course with an open mind. And no, this doesn't mean we're going to cast futures in a "no-risk" light. Sure, there's risk -- we will expose that too. We just want you to approach the course with an unbiased mind so that you can see the benefits -- as well as the risks -- and make an informed choice as to which strategies, if any, are best for you.

If you do, you will gain knowledge that will greatly change your perception of investing.