On the Table, A Bigger Risk For Investors
By Jerry Knight
Sunday, October 1, 2000; Page H01
Buried in a bill that's buried under the pile of legislation Congress is trying to clear off before it goes into reelection mode is a provision that would give gutsy investors a whole new game to play.
It would permit trading in futures contracts on individual stocks, an idea that's been kicking around Washington, Wall Street and the Chicago futures markets for 18 years. Futures contracts are obligations to buy or sell something at a set point in the future and at a set price.
Trading futures contracts on stock market indexes has become so much a part of the fabric of the markets that on weekday mornings the radio and TV tell us what's happening to the Standard & Poor's 500-stock index's futures. But futures on individual stocks have been forbidden by federal law.
Investors may not understand how the machinery works, but they know the S&P futures provide a preview of what's likely to happen when trading opens on Wall Street.
The same role could be played by individual stock futures, if Congress can get its act together and pass the measure before the members go home to protect their seats.
Last Friday, for example, investors could have seen Apple Computer stock falling if there had been futures contracts traded on Apple's stock, because the futures markets open well before the stock market. Apple shares lost roughly half their value in half an hour after the Nasdaq Stock Market opened Friday morning because the company warned that its fourth-quarter earnings would be far less than analysts had been expecting.
As it was, the only warning of how fast Apple would fall came from after-hours stock trading, which is often not a very accurate predictor of what's to come the following morning.
A market in individual stock futures, in fact, not only would have shown how far the Apple was falling from the tree, it might have made it possible for Apple shareholders to mitigate some of their losses. They could have protected themselves by selling Apple futures before the stock market opened.
And assuming there were futures not only for Apple but also for other prominent personal-computer stocks, investors might have been able to keep the rotten Apple from spoiling the whole barrel. The stocks of Intel, Microsoft, Dell and Sun all were soured by Apple.
But there is no trading now in Apple stock futures or any others.
Part of the reason is that the stock markets have been lobbying ferociously to maintain the federal ban on trading futures on individual stocks--divining the "right" price for each individual stock is, after all, why stock exchanges exist in the first place. The federal ban on individual stock futures was written when Congress set regulatory standards for stock index futures in 1982.
Trading futures on single stocks is a concept that is difficult to understand. In fact, it might not even work. This kind of contract has never been tried in any place with a serious stock market. If you saw a list of where individual stock futures are traded, your first question would be: They have a stock market? Would you believe Budapest?
Another part of the reason is that federal regulation of financial services has traditionally been based on the premise that if the government doesn't specifically permit something, you can't do it.
But now there is proposed legislation that would permit trading futures contracts on individual stocks. That is not the primary purpose of the bill. Its main goal is to clear up arcane legal questions about regulation of far more complex and esoteric financial transactions that are used by multinational banks and global corporations. It would settle long-standing turf battles between the Securities and Exchange Commission, which regulates stocks, and the Commodity Futures Trading Commission, which regulates futures.
Late Friday, congressional leaders and industry lobbyists were trying to cut deals to bring up a vote soon on what is known as the Commodity Futures Modernization Act of 2000.
In reality, it's not an act but a drama in four acts, with three different versions coming out of three different House committees and a fourth emanating from the Senate. As always, the devil is in the details, the little phrases that can mean millions to specific companies, billions to influential industries. Needless to say, no one is representing individual investors in these talks.
The basic principle involved is not a partisan issue. The Clinton administration is for it. The Democratic chairmen of both the SEC and CFTC are on board, as are the Republican chairmen of all the key congressional committees--Agriculture, Banking and Commerce. Federal Reserve Board Chairman Alan Greenspan, widely respected as an intellectual force on such matters, is a backer.
The New York Stock Exchange is leading the opposition, backed by the Nasdaq Stock Market and the various options exchanges. The Chicago Board of Trade, the Chicago Mercantile Exchange, the Futures Industry Association, the big banks and the big Wall Street firms are the principal proponents.
Campaign coffers are overflowing with checks, metaphorically paper-clipped to a memo explaining where the donor stands on these issues.
What's fascinating about the policy debate is the agreement on the guiding principle: The government should not stand in the way of financial innovation.
John Damgard, president of the Futures Industry Association, says it best: "Let the marketplace decide whether these are good products, not some GS-13."
Sorry 'bout that, bureaucrats, but that's the thinking these days.
Two other factors are driving the legislation: internationalization and technology.
The world has turned into one big market. Billions of dollars worth of yen, marks and pounds are traded in the United States every day. The London futures markets threatened to turn the tables on us a couple of weeks ago by announcing plans to trade futures on individual U.S. stocks. Nobody could have handed the American advocates a better weapon to wave in front of Congress.
In fact, international trading is easy with today's technology. The pits where agricultural futures are traded in Chicago and the equally fabled floor of the New York Stock Exchange are not going to get the stock futures business. They'll be traded electronically in a system modeled on the Nasdaq market.
The Chicago Mercantile Exchange has already established the model with a special version of its S&P 500 contract that was created for individual investors.
The S&P futures contract is far and away the world's most successful stock index vehicle. It is traded in quarterly cycles that are settled based on where the S&P ends up on the last trading day in March, June, September and December. The next contract coming due--right now, that's December--is where the action is. As of Friday, there were about 390,000 December contracts outstanding.
The big appeal of futures contracts is that traders do not have to pay the full value upfront, or even come up with the 50 percent margin required to buy stocks on credit. Instead they make a small down payment--also known as margin--that typically is 5 percent to 10 percent of the value of the contract.
That creates tremendous leverage. If a stock jumps 50 percent in value, the profit can be several times the amount invested. But the lever moves in both directions. If the value of the contract plunges, the trader not only loses the down payment but also must cover the full amount of the loss.
The bustling pits still trade the original S&P index futures contract, which represents $250 multiplied by the actual index. That's a wholesale-size contract, designed to serve the needs of institutions. On a day like Friday, when the S&P was down 21.78 points, the contract lost $5,445.
To attract individual traders, the Merc created an S&P "mini" contract that is valued at $50 times the index. Its moves are still hefty but more affordable; it dropped $1,089 on Friday.
The S&P mini is traded electronically and has attracted growing interest from online traders. Instead of sitting at their home computers trading one stock, they try to outguess the whole market by buying and selling the mini S&P, which had more than 31,000 contracts outstanding as of Friday.
The same kind of two-tiered market is expected to evolve for single stock futures.
There will probably be a "maxi" contract for institutions such as mutual funds, which will use it to manage their portfolios. When they think a stock is likely to fall, they can sell stock futures contracts and lock in the price without actually unloading the shares, which might drive down the market.
Officials at the Chicago Mercantile Exchange consider details of upcoming contracts a trade secret. But they make it very clear that if the government gives the green light, they will create contracts tailored to small traders. Most likely it will be 100 shares--the stock market's standard "round lot"--and it will be set up specifically to encourage online day trading.
Now, of course, day-trading stocks--popular as it may have become--has proved to be the riskiest business that small investors can get into. Even with a 50 percent down payment on stocks, traders can be wiped out in a single day.
That happened Friday to shareholders in Apple. On Thursday, Apple stock closed at $53.50 a share. It opened the next morning around $28 and soon slid to $25.75. Investors holding fully margined Apple shares were broke by the time the stock fell below $26.50.
But anyone who had purchased an imaginary Apple stock futures contract--locking in the obligation to buy the stock at a now-higher-than-market price--would have been in even deeper doo-doo. When the market opened at $28, such a buyer would probably have already lost the entire down payment and would have had to come with additional cash to cover the rest of the loss.
In the days before deregulation, a lot of people would have argued that investors should be protected from such big risks, but those days are over.
© 2000 The Washington Post Company
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