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by Howard Simons, NQLX's Special Academic Advisor.
Unlike other futures contracts, single stock futures (SSFs) in the United
States straddle two very different regulatory regimes and market structures,
those of exchange-traded futures and those of equities and their derivatives.
These differences are more than just an accident of history. While the
price action in both markets sends signals to both producers and consumers
on how to allocate new investment, futures and equities serve different
economic purposes. Futures exist for price discovery, risk management,
and the facilitation of commerce through mechanisms such as EFPs. The
equity markets exist to raise capital and to distribute the risks and
rights of ownership.
Other differences abound as well. You can start a lively debate among
technical analysts on whether the two markets can be traded with similar
systems, but one man’s opinion here, sure to raise hackles amongst
the devout, is that one size of trading system does not fit all. Here
are twelve reasons in support of this assertion.
- Stocks have no expiration date; they live for the
life of the issuing corporation. All futures contracts, no matter how
long-dated, have a finite life. As a result, all futures contracts have
a convergence to the price of their underlying asset. This diminution
of the basis creates artificial price movements that may not exist in
the underlying asset.
- A dividend-paying stock's price movements will be affected thereby.
Downward movements after the ex-dividend date or price movements induced
by dividend capture or avoidance strategies will distort the price history
of the issuing stock. Other and more significant corporate actions such
as stock splits, special dividends, rights offerings, etc., will produce
even greater distortions in the price history.
- Since the forward curve structures of many futures contracts, particularly
those of storable physical commodities, short-term interest rates and
currencies reflect hedgers' behavior and aggregate price expectations,
the price movement of the non-active months will reflect factors other
than the short-term search by price for underlying economic value. The
combination of these two factors renders all attempts to construct adjusted
long-term continuous futures contracts imperfect.
- The mechanics of indexation and portfolio balancing create money flows
into and out of a given stock for reasons wholly extrinsic to either the
fundamental developments in or the technical patterns of a given stock.
These price movements can be quite significant. The very act of including
or removing a stock from an index such as the S&P 500 or the NASDAQ
100 can raise or lower the price of the stock without regard to either
its fundamental outlook or its recent technical trading history.
- The reported price movements of U.S. equities occur during a consistent
set of trading hours and are produced by a consistent set of participating
traders, both American and international within those hours. The parallel
situation no longer holds for important futures contracts. Significant
price movements often occur during non-prime trading hours. For short-term
interest rate and currency markets, the very concept of a trading day
has been rendered artificial.
- The underlying asset for futures contracts either remains constant
or attempts are made to make it constant. The conversion factor contracts
for U.S. Treasury notes and bonds are an example of the latter phenomenon.
The issuing corporation for any common stock is a most non-constant entity.
As a result, the long-term price history of an underlying commodity such
as corn or natural gas can be studied for common technical and fundamental
relationships, while the long-term history of a corporation within a dynamic
economy has very little comparative constancy with its own history.
- Stock prices are far more volatile than those for storable commodities,
financial markets included. The fundamental value of any common stock
is its discounted stream of future dividends. This value is impossible
to ascertain. As a result, the opinions of analysts often are treated
as a fundamental reason to buy or sell a stock; no parallel situation
exists in the world of futures. Since price/earnings multiples can expand
indefinitely, stock prices can capitalize earnings unrealistic earnings
expectations. Since most commodities are factor inputs to other economic
processes, their prices are bounded by constraints of substitution and
elasticity.
- The bounded nature of commodity prices and the open-ended nature
of equity prices should encourage mean-reversion trading systems for futures
and trending trading systems for equities, yet the opposite appears to
be the common practice. Commodity traders tend to play for the low probability,
high-impact moves, while stock traders try to impose their views of fundamental
valuation on markets so difficult to price fundamentally.
- Stock prices tend to be more discontinuous than commodity prices;
earnings announcements after normal trading hours and economic reports
before normal trading hours can create numerous supply/demand imbalances.
It is not unusual in the specialist exchanges, the NYSE and the AMEX,
for trading to be suspended while either buyers or sellers are being sought.
The information flow into equity markets is more discontinuous than it
is in commodity markets. The concepts of insider trading and fair disclosure,
both mandated in American securities law, do not exist in futures markets.
- Buying and selling in futures markets occurs under symmetric
rules. There is no need to locate a physical supply of any commodity for
sale to short a futures contract, and there are no uptick rules in futures
trading. In fact, the most notable trading restrictions in the world of
futures are the mandated trading halts on stock index futures. They are
an import from and are coordinated with closures in the equity markets.
- The very different margin systems between the world of equities and
the world of futures creates different anxiety imperatives for traders
and distorts the price history of futures markets after a period of extended
volatility. Equity margins are set by the Federal Reserve under Regulation
T and are universal regardless of the volatility of the stock. Futures
margins are set by the exchanges and respond to increases or decreases
in the volatility of the underlying commodity. As futures margins inherently
are a lagging indicator, they tend to be raised at the end of a protracted
and volatile move and often contribute to its conclusion and reversal.
- Futures and stocks are taxed on a different basis. While the unrealized
capital gain on a stock is not subject to taxation under American law,
the unrealized open equity on a futures contract is taxed on December
31st of each year. Moreover, the frequent expirations of futures contracts
create a series of taxable events. Finally, the rules of hedge accounting
and FAS 133 create a different set of tax incentives for those who use
futures for hedging the risk of an underlying asset.
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