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Single Stock Futures And Alpha Management:

by Howard Simons, NQLX's Special Academic Advisor.

Alpha can be defined as the net risk-adjusted premium return from a position or a portfolio. It’s calculated by subtracting the portfolio’s return from the asset’s return, and can be conceived of as the average non-systematic deviation of a stock relative to an index. As an example, we can regress the daily returns for IBM against those of the S&P 500 over the December 1997 – December 2001 period and find an alpha of .07% per day for IBM. The beta, or relative volatility of IBM over this period was 1.0495. In the graph below, alpha is where the red trend line intercepts the Y-axis, and beta is the slope of the red line.

Since both of these measures are based on statistical relationships, they may be unstable over time. For example, if we shrank the estimation period for IBM to a December 1998 start, alpha would change to .06% and beta to 1.0855. These time-dependent coefficients may represent one of the biggest adjustments futures traders will have to make when they start trading single stock futures (SSFs). Since commodities do not by definition change over time, intermarket spreads such as wheat-corn tend to be far more stable than the matched-pair spreads that will be common in the SSF world. Of course, this situation does nothing other than create a trading opportunity.

Money managers ultimately earn their pay relative to the S&P 500 or another benchmark by adding or subtracting alpha. Here’s where SSFs could be used. Let’s say you want to delete a particular stock from an index, one that has a negative alpha. To sell this stock short in the cash market is cumbersome and expensive. It’s far easier and cheaper to delete it from your portfolio by selling the SSF.

You can even do this in a market neutral manner if you so desire, even though you’ll start to deal in institutional sizes. Let’s say IBM’s weight in the S&P 500 is 2.039%, and that the dollar value of the S&P Depository Receipt (“SPDR”) is $11,430 per round lot. This gives you an IBM exposure of .02039 * $11,430, or $233. If IBM is trading at $121.34, each IBM SSF will be worth $12,134 before basis adjustment. A fund manager could then delete IBM by selling one SSF against every 5,200 shares of SPDRs and have no exposure to the market’s overall direction.

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