Futures Education

SSF Relative Strength Trade

You may believe that regardless of overall market direction during the coming months, the stock of one company will gain in value relative to the stock of a different company. For example, you many think that Coke will grow faster than Pepsi. In the stock market you have many ways to take advantage of your forecast: you could buy Coke stock, you could Short Pepsi, or you could do both.
You could purchase futures contracts on Coke stock and sell futures contracts on Pepsi stock. Now instead of making money when the market goes up or down, you make money if the spread, or difference in value between the two companies, widens or narrows.
If both stocks move in the same direction and at the same rate, you will win on one contract and lose on the other. For example, let's suppose you buy a Coke SSF at $50 and sell a Pepsi SSF at $45. If both companies' stock goes up by $1, then you will make $100 on Coke and lose $100 on Pepsi, and the net effect will be breaking even. The same scenario applies to both Coke and Pepsi dropping in price, only now, you will make $100 on Pepsi and lose $100 on Coke.
There are two other possible scenarios. Coke could rise and Pepsi could stay the same or fall, or increase at a slower pace than Coke. This scenario is called a widening spread. Or, Coke could fall or stay the same, or increase at a slower pace than Pepsi. This is called a narrowing spread.
For every dollar that the spread widens, you profit $100. For each dollar the spread narrows, you lose $100. The following illustrates how this type of strategy works:

	If Price Difference Widens		If Price Difference Narrows
Opening Position	Price at Liquidation	Gain or Loss	Price at Liquidation	Gain or Loss
Buy Coke at $50	$53	$300	$53	$300
Sell Pepsi at $45	$46	-$100	$50	-$500
Net Gain or Loss		$200		-$200

As you can see from this example, you do not always have to know the direction a stock will travel; if you accurately predict how it will perform relative to another stock, you can make money using the SSF Relative Strength Trade.

SSF Short Hedge

A short hedge in single stock futures is designed to protect a long position in your stock. Since futures prices closely follow the stock prices, losses in the stock can be offset by gains in a short futures position. In this way hedging involves establishing a position in the futures market that is equal and opposite your position in the cash market, so that any loss incurred in one market will be offset by a gain in the other. The short hedge can be an excellent way to insulate your stock portfolio holdings against adverse price movements.
Let's assume you have a portfolio of stock with a large holding in IBM, 1,900 shares to be exact. IBM is reporting earnings next month and you are concerned that the news will not be good. You can protect your stock holding by selling an equivalent position in single stock futures. Since each contract controls 100 shares, you would actually sell 19 futures contract to completely protect against a potential drop in IBM share price. Should the price subsequently decline, the decrease in the value of the shares will be approximately offset by an increase in the value of the futures contracts.

Example

You own 1,000 shares of ABC, which is expected to report earnings next month. You want to hold on to your position to take advantage of the long-term upside potential but you are concerned about a short-term glitch. By selling futures contracts, you can protect yourself against the risk of a decline in its price. To accomplish this, you sell 10 100-share XYZ futures contracts priced at $50. When you think the stock has hit bottom, you buy back the futures contracts leaving the stock to appreciate as prices go back up.
The table below illustrates that the total value of your hedged stock holdings remains unaffected by either a price decline or a price increase.

Price Next Month	Value of 1000 Shares	Gain or loss on Futures	Total Value
$40	$40,000	+$10,000	$50,000
$50	$50,000	0	$50,000
$60	$60,000	-$10,000	$50,000

As the illustration clearly shows, if you hedge stock against an unfavorable price change you also give up the opportunity to benefit from a favorable price change.
Another variation of the short hedge is called the Ratio Hedge. A ratio hedge is similar in structure, but instead of hedging 100% of your stock position, you only hedge a percentage of your position. For example, if you own 1,000 shares of XYZ, you may choose to hedge 600 of the shares, leaving the remaining 400 shares to profit from a possible breakout. This popular strategy is often used to balance out risk to a more acceptable level.
You should also note that although these examples illustrate a "perfect" hedge, actual results vary one way or the other depending on the price relationship between the cash and futures markets. You will learn more about this in the arbitrage section.

SSF Long Hedge

In general, the long SSF hedge is used to lock in today's price for a future stock acquisition or distribution. This variation of hedging can be useful in a variety of possible situations. For instance, suppose you'd like to buy shares of XYZ because you expect it to appreciate, but the funds needed to acquire the stock won't become available for several months (e.g., money you expect to receive from a real estate closing or maturing investment holding). Buying a futures contract provides a way to establish a stock position at today's purchase price.
Or, as another possibility, assume you expect to acquire shares of a particular stock three months from now–perhaps from an estate distribution–but by then you are afraid the price may have declined. Selling futures contracts provides a way to lock in today's price.

Example

Assume that you won't have funds to buy a stock until a Certificate of Deposit (CD) matures next month, but you really like company XYZ and think the stock price will rally before you can get the money to buy the stock. To initiate a Long Hedge, you purchase 1 XYZ single stock future today for $50.
If the stock goes up to $55 when your CD matures, you will have already made $500 on the SSF and can turn around and sell the SSF and use the proceeds to purchase the stock - effectively reducing your cost basis to $50.

• If the stock goes down to $45 when your CD matures, you will lose $500 on the SSF, but you can pick up shares of stock for $45. Unfortunately, the cost basis in your stock will still be $50.
• If the stock stays right at $50, then you neither make nor lose money. You will be able to cash in the CD, buy the stock at $50 and sell the SSF for $50. Your long hedge has broken even.

SSF Portfolio Hedge

Based on market expectations, you may wish to temporarily increase the weighting of health care stocks in a portfolio while reducing the weighting of energy stocks–or vice versa. Rather than liquidate actual shares of stock, which might have adverse cost and tax considerations, it may be possible to achieve similar results by employing security futures contracts. This obviously involves some fairly complex calculations to determine which contracts and how many to purchase or sell to achieve the desired portfolio composition. This type of trading strategy needs to be monitored continuously for changes in the portfolio composition

SSF Arbitrage

An arbitrage is a unique strategy in futures. Arbitrageurs (aka Arbs) make sure that the cash price and the futures price of a stock remain relatively close. In actuality, futures prices and the underlying stock price are never exactly equal. They either sell for a slight premium or discount to the stock. The further out a future's expiration date, the greater the premium or discount will be. Arbs play an important role in price discovery, helping to ensure that a stock's cash price and futures price converge as the futures price comes closer to expiration. At expiration there should be no difference between the cash price and the futures price of the stock.
Here's how it works. Let's assume the stock is trading for $50 and the single stock future contract is trading for $51. The stock has some bad news and is heading down to $49.50, but the single stock futures are still trading at $51. The Arb will step in and quickly sell the SSF for $51 and buy the stock for $49.50. Purchasing the stock will put upward pressure on the stock, thereby pushing prices higher. Simultaneously, selling the single stock futures will put downward pressure on the futures price. The net effect will be to bring the cash price of the stock and the futures price of the futures closer together. When the futures expire, the Arb will deliver stock to cover his short position in the futures.
Due to the importance of executing an arbitrage at a precise time and condition, the Arbs generally utilize complex computer systems to help execute and manage their positions. You may hear on the news or read in stock reports that program buying or selling pushed the markets higher or lower. This is generally arbitrage buying or selling intended to bring the market back into fair value.

SSF and Equity Option Combinations

In addition to using different combinations of stock and single stock futures, you can also combine single stock futures and equity derivatives to create different risk and reward scenarios.
A common strategy among equity option traders is a trade known as the covered call. In this trade, the investor owns the underlying stock and sells equity call options against his or her stock position to generate income. It is considered a covered call because the underlying position of stock is used to satisfy an obligation to deliver stock to the buyer of the call option should the stock move higher.
Single stock futures can be used in place of the underlying stock to cover a short call position in the same way the stock covers a short call position at a fraction of the cost!
This is an example of how you could cross-margin single stock futures with equity options. Although optionsXpress does not employ cross-margin strategies, this is one application of the leverage possible in single stock futures.

Example

Suppose XYZ stock is trading for $50. The January 55 calls are selling for $2.50. Under a traditional covered call strategy you could buy 100 shares of stock for $5,000 and turn around and sell the calls for $250 in income. If the stock closes at $56, you will be called out of your stock, making a grand total of $750 on the entire trade ($250 from selling the option and $500 from the increase in the stock price).
Instead of buying the stock for $5,000, you decide to spend $1,000 on XYZ single stock futures. You turn around and sell a XYZ January $55 call and bring in $250 in premium. Now, when the stock goes up to $56, you sell the SSF for $56 and make $600. You have an obligation to deliver stock, so you go into the stock market and buy 100 shares of stock for $56, then turn around and give the stock to the option buyer for $55 - losing $100 on the transaction. Plus, you keep the $250 premium for the option. The net effect is +$600 on the SSF, -$100 on the stock and +$250 on the option, for a grand total of $750, the same as the covered call above - only you made it on a $1,000 investment. This is a 75% return on investment.
There are countless other combinations of single stock futures that we could explore, but let's keep it simple for now. As you can tell, single stock futures are quite versatile. They offer an efficient use your precious capital and they can be used to accomplish a multitude of objectives!