Security Futures—Know Your Risks, or Risk Your Future
Federal regulations permit trading in futures contracts on single stocks (also known as single stock futures or SSFs) and narrow-based security indices (see glossary below). This article describes what security futures are, how they differ from stock options, some of the risks they can pose, and how they are regulated.
Security futures involve a high degree of risk and are not suitable for all investors. As with any investment, if you don't understand it, you shouldn't buy it.
With security futures, you may lose a substantial amount of money in a very short period of time. The amount you may lose is potentially unlimited and can exceed the amount you originally deposit with your broker. This is because trading in security futures typically involves a high degree of leverage, with a relatively small amount of money controlling assets having a much greater value. Investors who are uncomfortable with this level of risk should not trade security futures.
What's a security futures contract?
A security futures contract is a legally binding agreement between two parties to buy or sell a specific quantity of shares of a security (i.e., common stock or an exchange-traded fund) or a narrow-based security index at a specified price, on a specified date in the future (known as the settlement or expiration date). If you buy a futures contract, you are entering into a contract to buy the underlying security and are said to be "long" the contract. Conversely, if you sell a futures contract, you are entering into a contract to sell the underlying security and are considered "short" the contract. The price at which the contract trades (or the “contract price”) is determined by relative buying and selling interest on a regulated U.S. exchange.
Security Futures Contract Specifications
Contract size—Each security futures contract has a set size. The size of a security futures contract is determined by the regulated exchange on which the contract trades. For example, a security futures contract for a single stock may be based on 100 shares of the underlying stock. For narrow-based security indices, the value of the contract is the price of the component securities times the multiplier set by the exchange as part of the contract terms.
Contract month—The month when the contract expires. There will be several different contract months available for trading at any one time, and the number of contract months may vary from exchange to exchange.
Contract expiration, last trading day—The expiration of a security futures contract is established by the exchange on which the contract is listed. On the expiration day, the contract terminates. Typically, the last trading day of a security futures contract will be the third Friday of the expiring contract month, and the expiration day will be the following Saturday.
Manner of settlement—Security futures may be settled by physical delivery of the underlying security or cash settlement. The terms of the contract dictate whether it is settled by cash or physical delivery.
Prior to expiration of the contract, investors realize their current gains or losses by executing an offsetting sale or purchase in the same contract (i.e., an equal and opposite transaction to the one that opened the position).
Contract Expiration and Delivery
Any futures contract that hasn't been liquidated by an offsetting transaction before the contract's expiration date will be settled at that day's settlement price (see glossary below). The terms of the contract specify whether a contract will be settled by physical delivery—receiving or giving up the actual shares of stock—or by cash settlement. Where physical delivery is required, a holder of a short position must deliver the underlying security. Conversely, a holder of a long position must take delivery of the underlying shares.
Where cash settlement is required, the underlying security is not delivered. Rather, any security futures contracts that are open are settled through a final cash payment based on the settlement price. Once this payment is made, neither party has any further obligations on the contract.
Margin and Leverage
When a brokerage firm lends you part of the funds needed to purchase a security, such as common stock, the term "margin" refers to the amount of cash, or down payment, the customer is required to deposit. By contrast, you should be aware that a security futures contract is an obligation and is not an asset. The contract has no value as collateral for a loan. When you enter into a security futures contract, you are required to pay a margin deposit or performance bond. These are good faith deposits to ensure your performance of obligations under the contract rather than down payments for the underlying securities.
For a relatively small amount of money (the margin requirement), a futures contract worth several times as much can be bought or sold. The smaller the margin requirement in relation to the underlying value of the futures contract, the greater the leverage. Because of this leverage, small changes in the price of the contract can result in large gains and losses in a short period of time.
Margin requirements for security futures contracts would be set by the exchange on which the contract is traded, subject to certain minimum standards set by law. The basic margin requirement is 15 percent of the current value of the security futures contract, although some strategies may have lower margin requirements. It is important to understand that individual brokerage firms can, and in many cases do, require margin that is higher than the exchange requirements. Additionally, margin requirements may vary from brokerage firm to brokerage firm.
Importantly, a brokerage firm can increase its “house” margin requirements at any time without providing advance notice, and such increases could result in a margin call. You should thoroughly read and understand the customer agreement with your brokerage firm before entering into any transactions in security futures contracts.
Note that a six percent decrease in the value of the contract resulted in a loss of 40 percent of the margin deposited. A 15 percent decrease in the contract price ($50 to $42.50) would mean a drop in the nominal value of the contract from $5,000 to $4,250, thereby wiping out 100 percent of the margin deposited on the security futures contract.
Adverse price movements that reduce the reserve below a specified level will therefore result in a demand from your broker that you promptly deposit additional margin funds to your account. Returning to our earlier example, the six percent decrease in the value of the contract that resulted in the loss of 40 percent of the margin deposit would reduce the margin deposit to $450. Therefore, the account holder would need to deposit $187.50 in the margin account to raise the margin level back up to 15 percent of the current value of the contract ($4,250).
Because of the always-present possibility of margin calls, security futures contracts are not appropriate if you cannot come up with the additional funds on short notice to meet margin calls on open futures positions. If you fail to meet a margin call, your firm may close out your security futures position or sell assets in any of your accounts at the firm to cover your margin deficiency. If your position is liquidated at a loss, you will be liable for the loss. Thus, you can lose substantially more than your original margin deposit.
Gains and Losses
Unlike stocks, gains and losses in security futures contracts are credited or debited to your account every day, based on the settlement price of the contracts at the close of that day’s trading. If the daily settlement price of a particular security futures contract rises, the buyer has a gain and the seller a loss. If due to losses your account falls below maintenance margin requirements, you may be required to place additional funds in your account to cover the margin deficiency.
Where Are Security Futures Permitted To Trade?
By law, security futures contracts must trade on a regulated U.S. exchange. Each regulated U.S. exchange that trades security futures contracts is subject to joint regulation by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The exchanges that are registered with the SEC for the purpose of trading security futures include:
- CBOE Futures Exchange (CFE)
- Chicago Board of Trade (CBOT)
- Chicago Mercantile Exchange (CME)
Variety of Security Futures Contracts
Contract specifications may vary from contract to contract. For instance, most security futures contracts require you to settle by making physical delivery of the underlying security, as opposed to making a cash settlement. Carefully review the settlement and delivery conditions before entering into a security futures contract.
Differences Between Security Futures and Stock Options
Although security futures share some characteristics in common with stock options, these products differ significantly. Most importantly, an option buyer may choose whether or not to exercise the option by the exercise date. Options purchasers who neither sell their options in the secondary market nor exercise them before they expire will lose the amount of the premium they paid for each option, but they cannot lose more than the amount of the premium. A security futures contract, on the other hand, is a binding agreement to buy or sell. Based upon movements in price of the underlying security, holders of a security futures contract can gain or lose many times their initial margin deposit.
All security futures contracts involve risk, and there is no trading strategy that can eliminate it. Strategies using combinations of positions, such as spreads (see glossary below), may be as risky as outright long or short futures positions. Trading in security futures requires knowledge of both the securities and the futures markets.
As noted above, before you trade security futures, you should read the Security Futures Risk Disclosure Statement. And bear in mind the following specific risks involved when trading security futures contracts:
- Trading security futures contracts may result in potentially unlimited losses that are greater than the amount you deposited with your broker. As with any high-risk financial product, you should not risk any money that you cannot afford to lose, such as your retirement savings, medical and other emergency funds, funds set aside for education or home ownership or funds required to meet your living expenses.
- Be cautious of claims that you can make large profits from trading security futures. Although the high degree of leverage in futures can result in large and immediate gains, it can also result in large and immediate losses. As with any financial product, there is no such thing as a "sure winner."
- Because of the leverage involved and the nature of futures transactions, you may feel the effects of your losses immediately. Unlike holdings in traditional securities, gains and losses in security futures are credited or debited to your account on a daily basis at a minimum. If movements in the markets for security futures contracts or the underlying security decrease the value of your positions in security futures contracts, you may be required to have or make additional funds available to your carrying firm as margin. If your account is under the minimum margin requirements set by the exchange or the firm, your position may be liquidated at a loss, and you will be liable for any deficit in your account.
- Under some market conditions, it may be difficult or impossible to hedge or liquidate a position. Generally, you must enter into an offsetting transaction in order to liquidate a position in a security futures contract. If you cannot hedge or liquidate your position, any existing losses may continue to mount. Even if you can hedge or liquidate your position, you may be forced to do so at a price that involves a large loss. This can occur, for example:
- If trading is halted due to unusual trading activity in either the security futures contracts or the underlying security;
- If trading is halted due to recent news events involving the issuer of the underlying security;
- If computer systems failures occur on an exchange or at the firm carrying your position; or
- If the market is illiquid and therefore doesn't have enough trading interest to allow you to get a good price.
- Under some market conditions, the prices of security futures may not maintain their customary or anticipated relationships to the prices of the underlying security or index. These pricing disparities can occur, for example, when the market for the security futures contract is illiquid and lacks trading interest, when the primary market for the underlying security is closed or when the reporting of transactions in the underlying security has been delayed. For index products, this could also occur when trading is delayed or halted in some or all of the securities that make up the index.
- You may experience losses due to computer systems failures. As with any financial transaction, you may experience losses if your orders cannot be executed normally due to systems failures on a regulated exchange or at the firm carrying your position. Your losses may be greater if your brokerage firm does not have adequate back-up systems or procedures.
- Placing contingent orders, if permitted, such as "stop-loss" or "stop-limit" orders, will not necessarily limit your losses to the intended amount. Market conditions may make it impossible to execute the order or to get the stop price.
- Day trading strategies involving security futures pose special risks. As with any financial product, seeking to profit from intra-day price movements poses a number of risks, including increased trading costs, greater exposure to leverage and heightened competition with professional traders.
- Tax implications. The tax implications of security futures may be complicated. You should consult a tax adviser before trading in these products.
Who Regulates Security Futures?
The CFTC and the SEC jointly regulate the trading of futures on single securities and narrow-based security indexes (i.e., security futures products), which have features of both futures and securities. Just as FINRA, subject to SEC oversight, oversees the securities industry by requiring registration of broker-dealers and subjecting members to its rules, examinations, and enforcement authority, the NFA performs similar functions as the self-regulatory organization for the futures industry.
Finding and Choosing a Broker
As an individual investor, you cannot trade directly on an exchange. Security futures transactions for individual investors must be handled by a broker. Most brokers are honest, competent professionals—and there are regulators, like FINRA, to help make sure that the few who are not are identified and disciplined—sometimes even barred from the industry.
Before you do business with any security futures professional or firm, you should check out their background. Both FINRA BrokerCheck and the NFA's Background Affiliation Status Information Center (BASIC) offer online access to important information about your broker or firm. These sites can provide a wealth of information about the professional background, business practices and conduct of firms and brokers. Your state securities regulator also may have additional information about securities professionals.
But there is more to finding a broker than knowing which ones might not be trustworthy. The key is finding the broker and firm that make you feel comfortable and best meet your personal financial needs.
Security futures positions may be held in either a securities or futures account. The protections for your funds and security futures positions differ depending on whether the account is a securities account or a futures account, so make sure you understand the regulatory protections available to your funds and positions if your firm fails. Your brokerage firm must tell you whether your security futures positions will be held in a securities account or a futures account. You also may have a choice about which type of account to hold your funds and positions.
- Protections for Securities Accounts — If you hold security futures contracts in a securities account, SEC rules prohibit a brokerage firm from using your funds and securities to finance its business. As a result, the brokerage firm is required to set aside funds equal to the net of all its excess payables to its customers (money the firm owes customers) over receivables from customers (money customers owe the firm). These rules also require the firm to segregate (hold separately) a customer's fully paid and excess margin securities.
If the brokerage firm becomes insolvent, the Securities Investor Protection Corporation (SIPC) protects cash and “securities” as defined under the Securities Investor Protection Act. SIPC protection also is available with respect to certain security futures contracts, and options on such contracts, where those instruments are held in a portfolio margining account carried by a SIPC-member brokerage firm as a securities account pursuant to a portfolio margining program approved by the SEC. Most brokers who are registered with the SEC are SIPC members; those few that are not must disclose this fact to their customers. To find out if your brokerage firm is a member of SIPC, you can check SIPC's database.
SIPC coverage is limited to $500,000 per customer, including up to $250,000 for cash. This coverage is limited to protecting funds and securities if the broker holding these assets becomes insolvent; these protections do not cover market losses. To learn more, read our article on SIPC protection.
- Protection for Futures Accounts — Cash held in a futures account must be segregated from the brokerage firm's own funds and cannot be borrowed or otherwise used for the firm’s own purposes. The firm cannot use your funds to margin or guarantee the transactions of another customer. The firm must add its own funds to the segregated account to cover another customer's debits or deficits. If the firm becomes insolvent, you may not be able to recover the full amount of your funds. Your account is not insured; however, customers with funds in segregation receive priority in bankruptcy proceedings.
Review your accounts statements and trade confirmations. If you believe you have been wronged or see a mistake in your account, act quickly. Immediately question any transaction you do not understand or did not authorize. Don't be timid or ashamed to complain. The securities industry needs your help so it can operate successfully. Here are the steps you should take:
- If you think it's a minor mistake, talk to your broker. This may be the fastest way to resolve the problem.
- If you can't resolve the problem with your broker or you believe your broker engaged in unauthorized transactions or other serious misconduct, report the matter in writing to the firm's management or compliance department.
- If you and your firm still can't resolve the problem, you have several options for resolving your dispute:
- Regulatory complaint programs. Investigating complaints from investors is a significant function of FINRA, the SEC and the NFA. Because the focus of these investigations is regulatory rather than compensatory, you should consider other avenues of dispute resolution if you are seeking to recover money or securities. You can file a complaint with FINRA if it's against a brokerage firm and its employees. NFA handles complaints against futures professionals. You also can file a complaint with the SEC.
- CFTC Reparations Program. The CFTC Reparations Program resolves disputes against commodity futures professionals that are registered with the CFTC and alleged to have violated the Commodity Exchange Act or CFTC regulations. You may seek actual damages (such as out-of-pocket trading losses). If you prevail, you also recover your filing fee.
- Arbitration and Mediation. Both FINRA and the NFA offer arbitration and mediation services. Arbitration is a dispute resolution mechanism that determines liability and whether parties are entitled to damages. Both actual and punitive damages may be awarded.
- Litigation. Although most new account agreements require you to pursue arbitration or mediation, you may be able to bring an action in federal or state court.
Checklist: Before You Trade
Read the Security Futures Risk Disclosure Statement, which includes a glossary of terms.
Check your broker's background by visiting either FINRA BrokerCheck or the NFA's Background Affiliation Status Information Center (BASIC).
Realize that security futures will expire and, unless you offset your position, you may have to deliver or accept delivery of the underlying security.
Have access to funds in case your losses exceed your original investment.
Understand the need to follow closely the price fluctuation of the underlying stock for any futures contract you might buy or sell.
Futures contract—A futures contract is: (1) an agreement to purchase or sell a commodity for delivery in the future; (2) at a price determined at initiation of the contract; (3) that obligates each party to the contract to fulfill it at the specified price; (4) that is used to assume or shift risk; and (5) that may be satisfied by delivery or offset.
Narrow-based security index—In general, an index that has any one of the following four characteristics: (1) it has nine or fewer component securities; (2) any one of its component securities make up more than 30 percent of its weighting; (3) the five highest weighted component securities together make up more than 60 percent of its weighting; or (4) the lowest weighted component securities making up, in the aggregate, 25 percent of the index's weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million).
Nominal value—The face value of the futures contract, obtained by multiplying the contract price by the number of shares or units per contract. If XYZ stock index futures are trading at $50.25 and the contract is for 100 shares of XYZ stock, the nominal value of the futures contract would be $5,025.
Settlement price—(1) The daily price that the clearing organization uses to mark open positions to market for determining profit and loss and margin calls and for invoicing deliveries in physical delivery contracts; (2) The price at which open cash settlement contracts are settled on the last trading day and open physical delivery contracts are invoiced for delivery.
Spread—(1) Holding a long position in one futures contract and a short position in a related futures contract or contract month in order to profit from an anticipated change in the price relationship between the two; (2) The price difference between two contracts or contract months.