Index Futures

What Are Index Futures?

The term index futures refers to futures contracts that permit traders to buy or sell a contract that is derived from a financial index today to be settled at a future date. Initially intended for institutional investors, index futures are presently open to individual investors too. Traders use these contracts to speculate on the price direction indexes, for example, the S&P 500 and the Dow Jones Industrial Average (DJIA). They additionally use index futures to hedge their equity positions against losses.

Understanding Index Futures

A index tracks the price of an asset or a group of assets, like equities, commodities, and currencies. A futures contract is a type of derivative that obligates traders to buy or sell the underlying asset on a set day at a predetermined price. An index future, therefore, is a legal contract that obligates traders to buy or sell a contract that is derived from a stock market index by a certain date at a predetermined price.

Index futures, which are additionally called stock or equity market index futures, function just like some other futures contract. They give investors the power and obligation to deliver the cash value of the contract based on an underlying index at a specified future date at an agreed-upon price. Unless the contract is loosened up before expiration through an offsetting trade, the trader is obligated to deliver the cash value on expiry.

Traders use index futures to hedge or speculate against future price changes in the underlying equity index. For example, the S&P 500 Index tracks the stock prices of 500 of the largest companies traded in the U.S. An investor could buy or sell index futures on the S&P 500 to hedge or speculate on gains or losses of the index.

Index futures don't predict future index performance.

Types of Index Futures

Some of the most famous index futures are based on equities, and that means investors hedge their bets on the individual index named in the contract.

For instance, traders can invest in the S&P 500 index by purchasing E-mini S&P 500 futures contracts. Investors can likewise trade futures for the Dow Jones and Nasdaq 100 Index. There are the E-mini Dow and E-mini Nasdaq-100 futures contracts, or their smaller variations the Micro E-mini Dow and Micro E-mini Nasdaq-100.

Outside of the U.S., there are futures available for the DAX Stock Index of 30 major German companies and the Swiss Market Index, the two of which trade on the Eurex. In Hong Kong, Hang Seng Index (HSI) futures permit traders to speculate on that market's major index.

Products might use different multiples to determine the contract price. For example, the E-mini S&P 500 futures contract, which trades on the Chicago Mercantile Exchange (CME), has a value of $50 times the value of the index. So in the event that the index trades at 3,400 points, the market value of the contract would be 3,400 x $50 or $170,000.

The CME delisted the standard-sized S&P 500 index futures and options contracts in September 2021. These contracts were priced at $250 times the level of the S&P 500. That means on the off chance that the index traded at 3,400 points, the market value of the contract would be 3,400 x $250 or $850,000.

Index Futures and Margins

Futures contracts don't require the buyer to put up the entire value of the contract when entering a trade. Instead, they just require the buyer to keep a small portion of the contract amount in their account. This is called the initial margin.

Index futures prices can fluctuate altogether until the contract expires. Therefore, traders must have enough money in their accounts to cover a potential loss, which is called the maintenance margin. The maintenance margin sets the minimum amount of funds an account must hold to fulfill any future claims.

The Financial Industry Regulatory Authority (FINRA) requires a minimum of 25% of the total trade value as the minimum account balance, albeit some brokerages will demand greater than 25%. What's more, as the value of the trade moves before expiration, the broker can demand extra funds be deposited into the account. This is called a margin call.

It's important to note that index futures contracts are legally binding agreements between the buyer and seller. Futures differ from a option because a futures contract is considered an obligation. An option, then again, is considered a right the holder could conceivably exercise.

Profits and Losses from Index Futures

An index futures contract states the holder agrees to purchase an index at a specific price on a specified future date. Index futures typically settle quarterly in March, June, September, and December. There are typically several annual contracts too.

Equity index futures are cash-settled. This means that there's no delivery of the underlying asset toward the end of the contract. In the event that the price of the index is higher than the agreed-upon contract price at the expiry date, the buyer makes a profit while the seller (who is known as the future writer) suffers a loss. In the opposite scenario, the buyer suffers a loss while the seller makes a profit.

For example, on the off chance that the Dow closes at 16,000 toward the end of September, the holder with a September futures contract one year earlier at 15,760 ends up reaping a profit.

Profits are determined by the difference between the entry and exit prices of the contract. Likewise with any speculative trade, there are risks the market could move against the position. As mentioned earlier, the trading account must meet margin requirements and could receive a margin call to cover any risk of further losses. The trader must understand that many factors can drive market index prices, including macroeconomic conditions like economic growth and corporate earnings.

Index Futures for Hedging

Portfolio managers often buy equity index futures as a hedge against potential losses. In the event that the manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures.

Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline. In the event of a market downturn, the stocks inside the portfolio would fall in value, however the sold index futures contracts would gain in value, offsetting the losses from the stocks.

The fund manager could hedge all of the downside risks of the portfolio, or just to some extent offset it. The downside of hedging is that this reduces profits in the event that the hedge isn't required. So on the off chance that the investor from the previous section with a September futures contract shorts index futures and the market rises, the index futures decline in value. The losses from the hedge would offset gains in the portfolio as the stock market rises.

Speculation on Index Futures

Speculation is an advanced trading strategy that isn't suited for some investors. However, experienced traders tend to use index futures to speculate on the direction of an index. Instead of buying individual stocks or assets, a trader can bet on the direction of a group of assets by purchasing or selling index futures.

For example, to replicate the S&P 500 Index, investors would need to buy every one of the 500 stocks in the index. Instead, index futures can be used to bet on the direction of every one of the 500 stocks, with one contract creating the same effect of possessing each of the 500 stocks in the S&P 500.

By their nature, stock index futures operate differently than futures contracts. These contracts permit traders to buy or sell a specified amount of a commodity at an agreed-upon price on an agreed-upon date from now on. Contracts are typically exchanged for tangible goods like cotton, soybeans, sugar, crude oil, gold, and what.

Investors generally trade commodity futures as a method for hedging or speculate on the price of the underlying commodity. Unlike index futures, which are cash-settled, long position holders of commodities futures contracts should take physical delivery on the off chance that the position has not been closed out ahead of expiry.

Businesses frequently use commodity futures to lock in prices for the raw materials they need for production.

Examples of Index Futures

Here's a hypothetical example to demonstrate the way that investors can speculate utilizing index futures. Let's say an investor decides to speculate on the S&P 500. They buy the futures contract when the index trades at 2,000 points, resulting in a contract value of $100,000 ($50 x 2,000). The E-mini S&P 500 futures are priced at $50 multiplied by the index value.

Because index futures contracts don't require the investor to put up the full 100%, they need just to keep a small percentage in a brokerage account.

• Scenario 1: The S&P 500 Index falls to 1,900 points. The futures contract is currently worth $95,000 ($50 x 1,900). The investor loses $5,000.
• Scenario 2: The S&P 500 Index rises to 2,100 points. The futures contract is currently worth $105,000 ($50 x 2,100). The investor earns a $5,000 profit.

Features

• Index futures are contracts to buy or sell a financial index at a set price today, to be settled at a date from now on.
• Some of the most famous index futures are based on equities, including the E-mini S&P 500, E-mini Nasdaq-100 and E-mini Dow. International markets likewise have index futures.
• Portfolio managers use index futures to hedge their equity positions against a loss in stocks.
• These contracts were initially meant solely for institutional investors yet are presently open to anyone.
• Speculators can likewise use index futures to bet on the market's direction.

FAQ

Will Index Futures be Used to Predict Market Performance?

Index futures are generally considered a bet — not a predictor. Traders who invest in equity index futures bet or speculate on the index moving in a specific direction. Investors who take long positions speculate that the index's price will increase while those who take short positions bet that the price will drop. Different factors can move markets, and that means they can head down any path. In that capacity, there is no safeguard predictor for the market, including index futures.

How Do You Trade Index Futures?

Index futures are derivatives that give you the right and the obligation to buy or sell stock market indexes at a specified date in the future at an agreed-upon price. You might trade futures for indexes like the S&P 500, Dow Jones, Nasdaq 100 as well as foreign market indexes, like the FTSE 100 or the Hang Seng. To trade index futures, you'll need to open an account with a brokerage firm. Once your account is open, choose the index you need to trade and decide whether you need to go long (you believe the price will increase) or short (you believe the price will decrease). Be sure you keep an eye on your contract as it nears the expiration date.

Is Index Futures Trading Riskier Than Stock Trading?

Index futures are neither riskier or less riskier than stocks. That is because their prices depend on the prices of the underlying index. The risk comes from speculative positions taken by investors who use leverage to make their trades. However, they are likewise used as a hedging instrument, which can reduce an investor's overall risk.