In my experience, futures contracts are a perfect fit for individual investors who are a) seeking to build exposure in an IRA outside of stocks and bonds and b) implementing a non-traditional, hedged strategy such as a long/short or Global/Macro portfolio.

For those with the most of their nest egg in individual retirement accounts (IRAs), futures are perhaps the only truly effective means of protecting your assets and preventing a decline in your standard of living. Stock market futures are simple to trade, inexpensive to trade, give you direct exposure and can easily be diversified.

Stock market futures trading is definitely an intimidating concept, but that doesn't mean that you can't learn it. There are a lot of nuances to trading stock market futures within your IRA, but nothing that cannot be overcome with several hours of homework.

Opening the Proper Brokerage Account

The first step is to open an IRA account at a brokerage firm that allows for stock market futures trading. While many of the big boys do not permit individual investors to do this, there are well established online brokers who do.

For my advisory business, I use Interactive Brokers. I would also suggest (not recommend, just suggest) checking out Think or Swim, which is now owned by TD Ameritrade (Nasdaq: AMTD). Think or Swim does a very good job of educating and servicing their customers, but I trade with Interactive Brokers for a few reasons -- the main one being they allow my IRA accounts to trade futures. It doesn't hurt that their commissions and execution are highly favorable as well.

E-Minis & Single Stock Futures

There are two types of futures contracts that are effective in an IRA account -- e-minis and single stock futures (SSFs). E-minis are a fraction of the size of full-size equity index contracts that track the price of an underlying index such as the S&P 500.

E-minis are simply smaller versions of the futures contracts the big boys use. But just because they're smaller doesn't mean they're small enough for everyone. For example, the e-mini contract that tracks the S&P 500 index has a nominal value of $65,000 when the S&P 500 is at 1300. E-minis trade at a fraction of normal futures contracts, which make them almost perfect for individual investors with smaller pools of capital.

If you're priced out of e-minis, or if you're bearish on an individual company, you can sell single stock equity futures (SSFs). SSFs track the price of an individual stock and may be adjusted for future dividend payouts. The nominal value of a single stock equity futures contract is 100x the price of the stock. This makes sense because one futures contract represents 100 shares of the stock. The following is a sample of a few SSFs' nominal values on May 25th, 2011*:

short-in-IRA-article

*Futures prices will not be exactly 100x the underlying due to the impact of time value of money and expected dividends. This is only a guideline.

Most e-mini contracts are traded on the Chicago Mercantile Exchange (CME). All SSFs are traded on the Chicago One Exchange, and their website lists all the available stock market futures. Your broker will also have a list of all the ticker symbols for each futures contract. While the list is fairly inclusive, many of the contracts will have liquidity issues which I’ll delve into later.

The advantage to SSFs is that individual stocks will go to zero while stock indexes rarely do. It is possible to achieve a 100% return on your investment if you short a stock by either borrowing it or selling a futures contract on it, and the price of the underlying stock goes to zero. In fact, no matter when you short a stock, you will generate a 100% gain if the price does indeed go to zero.

Another advantage to shorting individual companies is that there is always something going down, even if the rest of the market is going up. For example, the stock market is up year-to-date as of the writing of this post but there are several stocks like Bank of America (NYSE: BAC) and Goldman Sachs (NYSE: GS) that are down big. My firm’s short equity portfolio is actually showing profits YTD because of exposure to shares like these.

Even given the issues I'm going to explain momentarily, I’ve successfully traded SSFs for my clients, and it is my favorite way to build short positions in IRA accounts. There is a small learning curve, but once that barrier is overcome, using SSFs in an IRA account is a quick, simple and inexpensive means of achieving “true short exposure.” The issues with liquidity and security size are minor compared with the futility of owning inverse funds.

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Four Risks to Consider When Trading Stock Market Futures in Your IRA

You need to be aware of four risks whenever you decide to venture into the stock market futures arena:

  1. Contract size
  2. Liquidity
  3. Margin requirements and leverage risk
  4. Delivery

#1: Contract Size

E-minis: Futures contracts were not originally designed for your “mom and popretail investor; they were created for large institutional investors. With their rise in popularity, mini-contacts have been created for equity index futures but even the mini-contracts are sizeable. As mentioned earlier, the nominal value of an e-mini contract which tracks the S&P 500 index is $65,000 when the S&P 500 is at 1300.

SSFs: The nominal value of a single stock equity futures contract is 100x the price of the stock. This makes sense because one futures contract represents 100 shares of the stock. For stocks with a lower price, this might not be such an issue. But for a stock priced in the hundreds of dollars, the cost of the contract maybe prohibitive.

As you can see from the table above, a stock like Google (Nasdaq: GOOG) may require an excessively large allocation of your portfolio to build a position equal to one contract. If you are uncomfortable allocating such a large percentage of your account to a single short position, you will need to focus on lower priced stocks.

#2: Liquidity

E-minis: E-mini futures contracts that track large stock indexes like the S&P 500 tend to be pretty liquid. You may find that the difference in the bid-ask spread is 5 -20 bps, which can eat into your returns if you trade often enough (bps is trader lingo for 'basis points,' and 100 bps = 1%).

For those looking to hold a position long-term and roll contracts every quarter, the spread will have a negligible impact on your long-term returns. Any losses incurred via the bid-ask spread will be far less than the 150 bps (1.5%) you’d lose by paying a fund to do the same thing you can do yourself.

SSFs: The bid-ask spread on the single stock contracts can be far greater. In fact, I’ve found that it can be upwards of 100+ bps. In one case, I found a contract that had a spread of 400+ bps (obviously, I passed on that trade). For larger capitalized stocks like IBM (NYSE: IBM), Intel (Nasdaq: INTC) or JP Morgan (NYSE: JPM), one might expect a 20-30 bps spread. Virtually any stock in the S&P 500 should have a futures contract that is liquid enough to trade without the spread taking too big of a bite out of your overall returns.

However, it's important to note that once you get into the mid-cap stocks, you should expect to take a hit on the spread. And don’t expect to be able to put in a sell order at the ask price and have it executed unless the price moves against you in the underlying. The market is made by large institutions who are seeking to make arbitrage profits on the spread, so you will rarely be trading with other investors. You'll be dealing almost exclusively with market makers who make all their profits by closely managing the bid-ask spread.

You definitely do not want to put a sizable order for a futures contract “at the market” because you have no idea what the execution price will be. I’d recommend always putting a limit order in to make sure you achieve decent execution. If you decide to go this route, you’ll see the bid or ask pop right after a trade is executed trying to catch investors putting in market orders.

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Warning for Technical Traders: The price of the contract will not be exactly equal to the underlying, especially if the stock pays a regular dividend. You'll want to avoid putting a stop order for the futures contract at the exact price you would put the stop for the underlying stock. Second, if you place a simple stop order, the order will become a market order when the stop is triggered and you don’t know what type of execution you will get. My solution is to simply place alerts at my stop price for the underlying and then enter a limit order for the futures contract if the alert is triggered.

#3: Margin and Leverage Risk

Futures contracts are highly leveraged, so there's no need to add more leverage. At IB, a strict short position in a SSF requires only 20% margin, which means you could theoretically leverage up your portfolio nearly 5:1. If you so choose, you could build futures positions far in excess of your capital. But I cannot stress enough that leveraging up your portfolio, especially in an IRA, is a fool’s game.

I highly recommend that you are never overly exposed by building positions in excess of your account’s capital, especially in an IRA account. You may want to invest the balance of your capital in a low-risk, income-producing security like short-term Treasuries but be sure that these positions are not volatile because your short equity positions will be. The history of the markets is littered with investors who were right on an idea but were overleveraged and were forced to liquidate at the exact wrong time -- leading to bankruptcy.

#4: Delivery

There is one more nuance that anyone trading futures in an IRA account must be aware of before venturing into the marketplace. An IRA cannot take delivery of short positions, nor can it “borrow shares”.

For this reason, you must, and I emphasize must, liquidate the contract before it expires if you are trading within your IRA. If you do not, the IRA account will take delivery of a short position which is not allowed. If you fail to liquidate your position, the broker will likely liquidate the delivered position immediately which may result in an unfavorable price execution and some nasty messages from the compliance department.

SSFs: If you're trading SSFs, you’ll have to roll the contract before the expiration date. An underlying stock will typically have contracts that expire each month, but I’ve found that certain months are far more liquid. These months tend to be the last month of a quarter. So I typically sell a March, June, September or December contract with a 3-4 month time horizon and then I only need to roll the contracts every few months.

The expiration for all stock market futures is the third Friday of every month so you’ll need to be out of the position before the close of that day. Given the liquidity issue, I’d suggest rolling your position several days if not weeks before expiration.

The Investing Answer: Stock market futures trading is definitely an intimidating concept, but that doesn't mean that you can't learn it. There are a lot of nuances to trading stock market futures, but nothing that cannot be overcome with several hours of homework.

In my experience, futures contracts are a perfect fit for individual retirement accounts because they are simple to trade, inexpensive to trade, give you direct exposure and can easily be diversified.

If you decide to go the stock market futures route and would like professional assistance, my firm is focused on offering solutions for retail investors. We manage several strategies, including commodity themes and stock market themes designed to specifically hedge against rising commodity prices and/or stock market crashes.

Good Luck!

This is a guest post from Matthew McCracken, a Texas-based Registered Investment Adviser (RIA) and founder of McCracken & Company. Matt founded his own advisery firm in 2005 with the goal of providing financial security to middle-class Americans. He takes a Global/Macro approach to the markets which he marries with analytical tools to time trades in his preferred investment themes. Matt has held long positions in gold, silver and agricultural commodities since 2006, and shorted the investment banks and housing stocks from 2006 though 2008.