INVESTMENT OUTLOOK : PERSONAL FINANCE : GOING FOR BROKE : Stock Index Futures Are the Ticket for Investors Interested in Taking a Gamble
So the stock market crash and the gyrations that followed left your net worth in shreds. Your portfolio looks like the dog chewed it up and spit out what was indigestible. You want to take your remaining few grand and enjoy a fling before filing for bankruptcy.
Wall Street still has a place for you.
Or, more precisely, LaSalle Street in Chicago has a place for you.
It’s called the Standard & Poor’s 500 pit at the Chicago Mercantile Exchange. The pit is where you can bet on one of the most volatile, speculative and hyperactive commodities in the world--the stock market itself.
Leigh A. Stevens is a specialist in the risky arena of futures trading at the New York investment house of Paine Webber. When asked recently to name the most speculative investment available, he did not hesitate.
“It’s stock index futures,” he said.
Investing used to be fairly simple. There were stocks and there were bonds. But there also were people who had an urge for something a little more exotic, a little riskier. In the early years of this century, a young speculator named Bernard Baruch used to roam the floor of the New York Stock Exchange betting fellow traders on whether the next trade across the tape would be up or down.
Imagine how much at home the famed financier would feel in the pit at the Merc where fortunes are made, and lost, at a dizzying pace as traders scream their buys and sells in reaction to every tick of the stock market.
Today, the ability to bet on the direction of the stock market--and a lot of other commodities--has been institutionalized as part of what Business Week dubbed “the casino society” in 1985.
In little over a decade, inventive financiers have created a complex array of mechanisms that provide more bang for the buck. You just have to be certain you don’t shoot yourself in the foot.
Obviously, if you are going for broke there are avenues like investments in jojoba beans, new magazines, titanium and undeveloped land. But there long have been plenty of ways to speculate even for people who want to stick to the stock market.
Take, for example, stock options, one of the market’s oldest and most popular speculative vehicles. Stock options give the purchaser the right to buy or sell a specific number of shares of an individual stock at a set price within a specified period. The cost of the option is a fraction of the actual value of the stocks, so the potential return is vast.
Once available only through traders known as specialists, stock options were standardized in 1973 and are now listed on exchanges.
A standard options contract covers 100 shares of stock and comes in two varieties. An investor who believes that a particular stock will go up within the specified period of time buys a “call” option. The call conveys the right to buy shares of the underlying stock at a fixed price before a certain date.
An investor who thinks the price of the stock will drop buys a “put” option, which carries the right to sell a specified number of shares within a certain period. The put’s value increases as the underlying stock falls.
For instance, a speculator can buy one call option and receive the right to buy 100 shares of XYZ stock at $50 a share by a given day. The price of the option is a function of supply and demand, but say it is 50 cents a share on a day XYZ is selling at $35 a share. That means that the investor controls $3,500 worth of XYZ for $50.
If the stock goes up to $40 a share by the given sell day, the investor can make, before trading fees are subtracted, $5 a share, or a total of $500--on an investment of $50. To earn $500 in a normal, unleveraged stock transaction, the investor would have had to put up $3,500 to buy that much real XYZ stock.
A stock option is a right, not an obligation, and the option expires if it is not exercised within the specified period of time. When that happens, the buyer loses the money invested in the option, in the above example, $50.
A variation on this theme of leverage is the futures contract, which is an agreement to buy or sell a specific amount of a commodity or financial instrument at a specified price on a particular date. Under a futures contract, however, the investor is legally obligated to buy or sell the underlying commodity, unless it is sold before the settlement date. This contrasts with options trading, since the options trader may choose whether or not to exercise the contract.
The next progression is stock index futures, which were created in 1982 as a way for investors to speculate on the general performance of the markets. They are usually tied to the Standard & Poor’s index of 500 stocks.
Those who sell futures contracts are making a bet that the stock market will go down, which sends the value of the futures contract up. The transactions are settled in cash, not the underlying stocks in the index, and they are good for up to three months.
Again, the investor pays only a fraction of the actual value of the basket of 500 stocks, but the rewards and risks are potentially enormous. The fraction, or margin, varies and it is set by the Merc.
Here is how it works for the S&P; 500 index: The investor puts up $20,000 and the amount of stock the money controls is determined by multiplying the level of the index by 500. If the index is 200, the money will control $100,000 worth of stocks.
The S&P; index moves about one point for every eight to nine points in the Dow Jones industrial average. Each point on the S&P; 500 is worth $500 to our stock futures contract.
Hence, if the S&P; index goes up 10 points in one day, the contract’s value increases $5,000. A straight investment of $20,000 spread among those same 500 stocks would be up less than $1,000.
By the same token, however, losses also are magnified. If the index drops 10 points, the value of the contract is down $5,000.
The profits or losses of each contract are figured at the close of every trading day and the owner can sell out at any point before the expiration date.
The recent volatility of the stock market demonstrates the potential rewards and losses of these contracts, which can be bought and sold many times throughout a day. For instance, the 508-point decline on Oct. 19 took down the S&P; 500 by 57.46 points. That plummet translates to a loss of $287,300 for the stock index contract.
The buyer is obligated to cover the transaction and cannot walk away, as one could with an option. So, the loss not only wipes out the $20,000 deposit but forces the investor $267,300 into the hole.
Two days later, a day when the Dow went up a record 186.84, the S&P; index rose 21.55. That represents a one-day gain of $107,750 for the futures contract.
So, if you are down to a few grand and don’t mind risking it, place your bet on the market. But there’s one thing to remember: A lot of people think this sort of speculation helped grease the skids for the market crash on Oct. 19 that nearly broke you in the first place.
