Using Index Futures To Predict The Future

By Neil O'Hara AAA

An index futures contract binds the parties to an agreed value for the underlying index at a specified future date. For example, the September futures contract for the current year on the Standard & Poor’s 500 Index reflects the expected value of that index at the close of business on the third Friday in September. Like any derivative, it’s a zero-sum game: One party is long and the other short - and the loser must pay the winner the difference between the agreed index futures price and the index closing value at expiration.
 
Fair Value of an Index Future
Although index futures are closely correlated to the underlying index, they are not identical. An investor in index futures does not receive (if long) or owe (if short) dividends on the stocks in the index, unlike an investor who buys or sells short the component stocks or an exchange-traded fund that tracks the index.
 
Index futures trade on margin, too: An investor who buys $100,000 worth of futures must put up around 5% of the principal amount ($5,000) at the outset, whereas an investor in the stock components or an ETF must put up the full $100,000.
 
The index futures price must equal the underlying index value only at expiration. At any other time, the futures contract has a fair value relative to the index, which reflects the expected dividends forgone (a deduction from the index value) and the financing cost for the difference between the initial margin and the principal amount of the contract (an addition) between the trade date and expiration. When interest rates are low, the dividend adjustment outweighs the financing cost, so fair value for index futures is typically lower than the index value.
 
Index Futures Arbitrage
Just because index futures have a fair value doesn’t mean they trade at that price. Market participants use index futures for many different purposes, including hedging; adjusting asset allocation through index futures overlay programs or transition management; or outright speculation on market direction. Index futures are more liquid than the market in the index's individual components, so investors in a hurry to alter their equity exposure trade index futures - even if the price isn’t equal to fair value.
 
Whenever the index futures price moves away from fair value, it creates a trading opportunity called index arbitrage. The major banks and securities houses maintain computer models that track the ex-dividend calendar for the index components, and factor in the firms’ borrowing costs to compute fair value for the index in real time. As soon as the index futures price premium, or discount to fair value, covers their transaction costs (clearing, settlement, commissions and expected market impact) plus a small profit margin, the computers jump in, either selling index futures and buying the underlying stocks if futures trade at a premium, or the reverse if futures trade at a discount.
 
Index Futures Trading Hours
Index arbitrage keeps the index futures price close to fair value, but only when both index futures and the underlying stocks are trading at the same time. While the stock market opens at 9:30am and closes at 4pm, index futures trade 24/7 on platforms like Globex, an electronic trading system run by CME Group. Liquidity in index futures drops outside stock exchange trading hours because the index arbitrage players can no longer ply their trade. If the futures price gets out of whack, they cannot hedge an index futures purchase or sale through an offsetting sale or purchase of the underlying stocks. But other market participants are still active.
 
Index Futures Predict the Opening Direction
Suppose good news comes out abroad overnight - the ECB cuts interest rates, or China reports stronger than expected growth in GDP. The local equity markets will probably rise, and investors may anticipate a stronger U.S. market, too. If they buy index futures, the price will go up. And with index arbitrageurs on the sidelines until the U.S. stock market opens, nobody will counteract the buying pressure even if the futures price exceeds fair value. As soon as New York opens, though, the index arbitrageurs will execute whatever trades are needed to bring the index futures price back in line - in this example, by buying the component stocks and selling index futures.
 
Investors cannot just check whether the futures price is above or below its closing value on the previous day, though. The dividend adjustments to index futures fair value change overnight (they are constant during each day), and the indicated market direction depends on the price of index futures relative to fair value regardless of the preceding close. Ex-dividend dates are not evenly spread over the calendar, either; they tend to cluster around certain dates. On a day when several big index constituents go ex-dividend, index futures may trade above the prior close but still imply a lower opening.
 
… In the Short-Term
Index futures prices are often an excellent indicator of opening market direction, but the signal works for only a brief period. Trading is typically volatile at the opening, which accounts for a disproportionate amount of total trading volume. If an institutional investor weighs in with a large buy or sell program in multiple stocks, the market impact can overwhelm whatever price movement the index futures indicate. Institutional traders do watch futures prices, of course, but the bigger the orders they have to execute, the less important the index futures direction signal becomes.

Late openings can also disrupt index arbitrage activity. Although the market opens at 9:30am, not every stock starts to trade at once. The opening price is set through an auction procedure, and if the bids and offers do not overlap, the stock remains closed until matching orders come in. Index arbitrage players won’t step in until they can execute both sides of their trades, which means the largest - and preferably all - stocks in an index must have opened. The longer index arbitrageurs stay on the sidelines, the greater the chances that other market activity will negate the index futures direction signal.
 
The Bottom Line
If the futures price suggests the market will rise on the opening, investors who wish to sell that day may want to wait until after the market opens before entering their order, or set a higher price limit. Buyers may want to hold off when index futures predict a lower opening, too. Nothing is guaranteed, however; index futures do predict the opening market direction most of the time, but even the best soothsayers are not always right.
 
Investors can monitor futures prices and fair values on websites like CNBC or CNN Money, both of which also show pre-market indications for individual stocks (a less reliable indicator due to poor liquidity).

comments powered by Disqus
Related Articles
  1. Predict Inflation With The Producer ...
    Forex Education

    Predict Inflation With The Producer ...

  2. Uncovering Oil And Gas Futures
    Active Trading

    Uncovering Oil And Gas Futures

  3. An Introduction To Real Estate Futures ...
    Home & Auto

    An Introduction To Real Estate Futures ...

  4. Introduction To Currency Futures
    Mutual Funds & ETFs

    Introduction To Currency Futures

  5. Invest In Hollywood With The Film Futures ...
    Active Trading

    Invest In Hollywood With The Film Futures ...

Trading Center