A:

Every morning before North American stock exchanges begin trading, TV programs and websites providing financial information will give the quotes for the S&P, Dow and Nasdaq futures contract. The quoted price movements of the futures contracts in early trading is used by some traders as a gauge for how the overall exchanges will perform at market open and over the trading day. If the index future is trading higher before the market opens, it generally means that the actual index will trade up in the early part of the day. This is because the index futures are closely tied to the actual indexes. These futures contracts mirror the underlying index and act as a precursor of the actual exchange index's direction.

A futures contract represents a legally binding agreement between two parties to pay or receive the difference between the predicted underlying price set when entering into the contract and the actual price of the underlying when the contract expires. Index futures trade with a multiplier that inflates the value of the contract to add leverage to the trade. The multiplier for the Dow is 10, for the Nasdaq it is 100 and it is 250 for the S&P.

For example, if a Dow Jones Index future is trading at 10,000, this means that if an investor purchased one futures contract, it would be worth $100,000. What this really means for the investor is that every one-point change in the Dow will cause a $10 change in real terms for the investor. If the Dow falls 100 points, the holder of the contract on the long side will lose $1,000.

Futures contracts are marked to market, meaning the change in value to the investor is shown in the investor's account at the end of each trading day until expiration. If the Dow falls 100 points in one trading day, at the end of the day, $1,000 will be taken out of the futures contract purchaser's account and placed into the seller's account. Because the index and the futures contract are so closely related both in price movement and value change, index futures are used to gauge the direction of the market.

For example, when the futures contracts on the S&P 500 trade higher, it means futures investors believe the actual exchange index will also trade higher once the markets open. DJIA futures contracts begin trading on the Chicago Board of Trade at 8:20am EST, just over an hour before the stock market opens for trading. The S&P 500 and Nasdaq 100 futures both open at 8:30am EST and trade on the Chicago Mercantile Exchange.

Major events and breaking news can occur during this one-hour window before the stock market opens; this news usually gets priced into the futures contracts, fluctuating like a normal index. This allows investors to use the futures prices to get a generalized view of market sentiment, and may help to position certain trading strategies before equity markets open.

(For a more in-depth look at futures, see our Futures Fundamentals Tutorial.)

RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  3. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  4. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
Related Articles
  1. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  2. Economics

    The History of Stock Exchanges

    Stock exchanges began with countries who sailed east in the 1600s, braving pirates and bad weather to find goods they could trade back home.
  3. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  4. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  5. Fundamental Analysis

    5 Predictions for the Chinese Stock Market in 2016

    Find out why market analysts are making these five ominous predictions about the Chinese stock market in 2016, and how it may impact the entire world.
  6. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  7. Economics

    How Interest Rates Affect The U.S. Markets

    When indicators rise more than 3% a year, the Fed raises the federal funds rate to keep inflation under control.
  8. Investing Basics

    Financial Markets: Capital vs. Money Markets

    Financial instruments with high liquidity and short maturities trade in money markets. Long-term assets trade in the capital markets.
  9. Options & Futures

    Contango Versus Normal Backwardation

    It’s important for both hedgers and speculators to know whether the commodity futures markets are in contango or normal backwardation.
  10. Economics

    The Ripple Effect: Interest Rates and the Stock Market

    Investors should observe the Federal Reserve’s funds rate, which is the cost banks pay to borrow from Federal Reserve banks.
RELATED TERMS
  1. Warrant

    A derivative that confers the right, but not the obligation, ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  4. Convergence

    The movement of the price of a futures contract towards the spot ...
  5. Futures Market

    An auction market in which participants buy and sell commodity/future ...
  6. Capital Markets

    Capital markets are markets for buying and selling equity and ...
Hot Definitions
  1. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  2. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
Trading Center