A stock index futures contract binds two parties to an agreed value for the underlying index at a specified future date. For example, the March futures on the Standard & Poor’s 500 Index reflects the expected value of that index at the close of business on the third Friday in March. Like any derivative, it’s a zero-sum game because one party is long the futures contract 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. However, many futures contracts are closed well before the 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 the component stocks or an exchange-traded fund that tracks the index.

Key Takeaways

  • Stock index futures, such as the S&P 500 E-mini Futures (ES), reflect expectations about the price of a stock index at a later time, given dividends and interest rates.
  • Index futures are agreements between two parties and considered a zero-sum game because, as one party wins, the other party loses, and there is no net transfer of wealth.
  • While trading in the U.S. stock market is most active from 9:30 a.m. to 4:00 p.m. ET, stock index futures trade nearly 24/7.
  • The rise or fall in index futures outside of normal market hours is often used as an indication of whether the stock market will open higher or lower the next day.
  • When index futures prices deviate too far from fair value, arbitrageurs deploy buy and sell programs in the stock market to profit from the difference.

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 the 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 U.S. stock market opens at 9:30 a.m. and closes at 4 p.m., 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 becomes irregular, 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 trade on margin, which is a deposit held with the broker before a futures position can be opened. For example, an investor who buys $100,000 worth of futures must put up a percentage of the principal amount and not the entire $100,000.

Index Futures Predict the Opening Direction

Suppose good news comes out abroad overnight, such as a central bank lowers interest rates or a country 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 Stock Exchange opens, though, the index arbitrageurs will execute whatever trades are needed to bring the index futures price back inline—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 bell on Wall Street, 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 bulk of trading on the NYSE begins at 9:30 a.m. ET, not every stock starts to trade at the same time. For some stocks, 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 S&P 500 Index futures move higher outside of market hours and suggest the stock 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 sometimes wrong.