Security Futures
Security futures are a type of derivatives contract representing a legally binding agreement to purchase or sell a specific quantity of shares of a single equity security or a narrow-based securities index at a predetermined price on a future date. As financial instruments, security futures allow investors to speculate on the future price movements of the underlying asset without directly owning the asset itself, providing opportunities for both hedging and speculation within the broader category of derivatives. They are exchange-traded products, meaning they are standardized and traded on regulated exchanges.
History and Origin
The ability to trade security futures in the United States was largely enabled by the passage of the Commodity Futures Modernization Act of 2000 (CFMA).4 Prior to this legislation, futures contracts on single stocks and narrow-based security indexes were generally prohibited. The CFMA lifted this ban, establishing a framework for their joint regulation by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). This legislative change allowed for the introduction of these products to the U.S. market, aiming to provide investors with new tools for managing price risks in equity markets and for capitalizing on anticipated price movements.
Key Takeaways
- Security futures are a type of derivative that obligates parties to buy or sell an underlying security or narrow-based index at a future date for a predetermined price.
- They are jointly regulated by the CFTC and the SEC in the United States, following the Commodity Futures Modernization Act of 2000.
- These instruments offer high leverage, meaning a small capital outlay can control a large position, amplifying both potential gains and losses.
- Security futures can be used for hedging existing stock portfolios or for speculation on the future price direction of an underlying asset.
- Investors must trade security futures through a brokerage firm that is registered with both the SEC and the CFTC.
Interpreting Security Futures
Interpreting security futures involves understanding the relationship between the contract's price and the underlying security's spot price, as well as the impact of time to expiration, interest rates, and dividends. A security future's price will generally track the price of its underlying stock or index, adjusted for factors like the cost of carry (financing costs minus dividends). Traders interpret market sentiment and anticipated price movements of the underlying asset to take positions in security futures. For example, if an investor expects the price of a stock to rise, they might buy a security futures contract, anticipating that the contract's value will increase in tandem with the stock's price. Conversely, if they expect a price decline, they might sell a security futures contract. The difference between the futures price and the spot price of the underlying asset can indicate market expectations regarding future supply and demand or financing costs. Understanding concepts like volatility is also crucial, as higher volatility can lead to wider price swings in the security futures contract.
Hypothetical Example
Consider an investor, Sarah, who owns 500 shares of TechCorp stock, currently trading at $100 per share. She is concerned about a potential short-term decline in the stock's price but does not want to sell her shares. To mitigate this risk, Sarah decides to use security futures for hedging.
She looks up TechCorp security futures contracts expiring in three months, which are quoted at $99.50 per share. Each contract represents 100 shares. To hedge her 500 shares, she sells five (500 shares / 100 shares per contract) security futures contracts. This is equivalent to taking a short position on 500 shares.
Sarah is required to deposit an initial margin in her margin account with her broker, typically a percentage of the contract's total value. Let's assume a 20% initial margin requirement. For a total contract value of $49,750 (5 contracts * 100 shares/contract * $99.50/share), her initial margin would be $9,950.
Scenario 1: TechCorp stock declines.
Suppose, after three months, TechCorp's stock price falls to $90 per share. The security futures contracts will also likely drop in value. Sarah can then buy back (offset) her five short security futures contracts at approximately $90 per share.
Her profit from the security futures: (Initial selling price $99.50 - Buy-back price $90) * 500 shares = $9.50 * 500 = $4,750.
This profit helps offset the loss in value of her physical TechCorp stock holdings (500 shares * ($100 - $90) = $5,000 loss). While not a perfect hedge, it significantly reduces her overall loss.
Scenario 2: TechCorp stock increases.
If TechCorp's stock price instead rises to $110 per share, the security futures contracts would also increase. Sarah would have to buy back her short contracts at approximately $110 per share.
Her loss from the security futures: (Initial selling price $99.50 - Buy-back price $110) * 500 shares = -$10.50 * 500 = -$5,250.
However, this loss is offset by the gain in her physical TechCorp stock holdings (500 shares * ($110 - $100) = $5,000 gain). This illustrates that while security futures can protect against downside, they also limit upside potential when used for hedging.
Practical Applications
Security futures serve several practical applications in financial markets, primarily for managing risk and for speculative trading. Investors and institutions use them to hedge existing equity positions against adverse price movements, similar to the hypothetical example. By taking an opposing position in security futures to their physical stock holdings, investors can mitigate potential losses.
For speculators, security futures offer a highly leveraged way to gain exposure to individual stocks or narrow-based indexes. With a relatively small initial margin deposit, traders can control a much larger value of the underlying asset, allowing for magnified gains from anticipated price changes. Conversely, this also means magnified losses.
They are also used by market makers and arbitrageurs who seek to profit from temporary price discrepancies between the security futures contract and the underlying stock. The joint regulation of security futures by the CFTC and the SEC ensures oversight of these products and the entities that trade them.3 The transparency provided by exchange trading and clearing through a clearinghouse like the Options Clearing Corporation (OCC) helps reduce counterparty risk.
Limitations and Criticisms
Despite their utility, security futures come with significant limitations and criticisms. A primary concern is the inherent high leverage they offer. While leverage can amplify gains, it equally amplifies losses, potentially exceeding the initial investment. This characteristic makes them unsuitable for all investors, especially those with a low tolerance for risk. Investors may also face margin calls if the market moves against their position, requiring them to deposit additional funds to maintain their contract. Failure to meet a margin call can lead to the forced liquidation of their position at a loss.
Another criticism revolves around their liquidity, especially for contracts on less actively traded stocks or those with longer expiration dates. This can result in wider bid-ask spreads and difficulty in entering or exiting positions at desired prices. Some market participants also note that despite their regulatory legalization, single stock futures, in particular, have not achieved the same trading volumes or popularity as other options contracts or traditional futures contracts on broad-based indexes. This limited market adoption can be attributed to several factors, including regulatory complexities and competition from other derivative products.2 The specific requirements for these products are detailed in regulatory frameworks such as 17 CFR Part 41.1
Security Futures vs. Futures Contracts
While security futures are a type of futures contract, the term "futures contracts" generally refers to a broader category of derivatives that obligate the buyer and seller to exchange an asset at a predetermined price and date. The key distinction lies in their underlying assets and regulatory oversight.
| Feature | Security Futures | Futures Contracts (General) |
|---|---|---|
| Underlying Asset | Single equity security or narrow-based security index | Commodities (oil, gold, agricultural products), currencies, interest rates, broad-based stock indexes |
| Regulation | Jointly regulated by the CFTC and SEC | Primarily regulated by the CFTC |
| Purpose | Hedging/speculating on individual stocks/narrow indexes | Hedging/speculating on a wide range of assets, including commodities and broad market indexes |
Confusion often arises because both involve standardized contracts and margin account trading. However, the specific regulatory framework and the nature of the underlying asset differentiate security futures from other futures contracts. Security futures are explicitly defined and regulated under both securities and commodities laws, reflecting their hybrid nature.
FAQs
What is the primary purpose of security futures?
The primary purpose of security futures is to provide investors with a tool to manage price risk (hedging) in individual equity securities or narrow-based indexes, and to offer opportunities for speculation on their future price movements.
Are security futures suitable for all investors?
No, security futures involve a high degree of risk, primarily due to the significant leverage they offer. The potential for losses can exceed the initial initial margin deposited, making them generally suitable only for experienced investors who understand the risks involved and can afford potential losses.
How are security futures regulated?
In the United States, security futures are subject to joint regulation by both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). This dual oversight stems from their nature as both securities and futures contracts.
What is a margin call in the context of security futures?
A margin call occurs when the equity in an investor's margin account falls below the required maintenance margin level. This typically happens when the market moves unfavorably against a position. The investor is then required to deposit additional funds to bring their account back to the minimum margin requirement, or their position may be liquidated.