So you’ve mastered the science of investing in individual stocks, and now have no idea what to do with your countless billions in profit. If you like a challenge that offers lots of downside, cast your gaze upon stock index futures, the training wheels of derivative instruments.

Futures contracts, in general, developed as a way of trading risk. Say you’re a sorghum farmer who’s used to getting $300 a ton, which might usually be enough to take care of the mortgage payment and put a little something away for retirement. But last year, a record harvest meant there was a surplus on the market and the price fell to $150. That’s a mild inconvenience if you’re an investor, but calamitous if you make you're living by the combine harvester. (For related reading, see: Using Index Futures To Predict The Future.)

So futures were invented. A futures trader signs a contract whereby she promises to purchase 1,000 tons of sorghum next March at perhaps $295 a ton. The farmer thinks, “better that than I fall victim to the whims of the market again. A bird in the hand...” The farmer sells risk to the buyer, who’s wagering that she’ll be able to profit and that the market price will turn out to be more than $295. At which point she’ll sell. (Sorghum, by virtue of being a commodity, is bought to be sold. The trader’s not going to eat 1,000 tons of the stuff, after all.)

Offloading Risk...and Some Upside

The drawback for the farmer is that next year’s price might be $500 a ton. If it is, he can either kick himself for having committed to the futures contract months ago, or, if he’s a glass-half-full guy, rejoice that he protected himself from a drop in price.

In modern times, speculators have ended up taking over both sides of most futures transactions. Once the commodity is sold by the source, there’s no reason why it can’t be bought and sold and speculated upon again, and those deals will typically happen between professional speculators rather than between a speculator and a producer. (For more, see: What Do The S&P, Dow and Nasdaq Futures Contracts Represent?)

Not Just Sorghum and Yen

From their onset until the 1980s, futures contracts were mostly per our example – agricultural. That made sense: foodstuffs are so vital, and their prices and quantities so dependent on external forces, that they needed a little stabilization. These days, the underlying commodities in most futures contracts are financial instruments. That category includes currencies, and occasionally, stock indices. Yes, an investor (or in practice, a stock portfolio manager) can write a contract on what level the Dow or some other index is going to be at some certain time. Such stock market future trading can be performed with the CME Group, Inc.'s (cme)/"E-mini" line of stock index future products, among other products. These contracts are traded exclusively on a variety of electronic trading platforms and constructed with relatively modest contract sizes.

The CME, parent of the Chicago Mercantile Exchange and several others, offers futures contracts on the level of the S&P 500 (CME Group owns the S&P 500 index and several other indices). You can buy futures contracts on what level the S&P 500 will be at on certain future dates. Specifically, every quarter (March, June, September, December). Keep in mind that stock index futures are not buy-and-hold investments; they're short-term trading vehicles by nature.

For Example...

At the close of trading on Aug. 22, 2014, the S&P stood at 1,988. At that same time, the price of an S&P 500 futures contract that closes in September was 1,993¾. So en masse, the market believes that the index will gain 5¾ points by the end of the next month. You can purchase such a contract for $50 per point, or $99,687.50 (there are futures contracts available at other prices, too. $50 per point is among the cheapest). On the delivery date, you note where the S&P 500 is sitting and either click your heels or hang your head. Let’s say that on the closing date in September, the S&P 500 has risen to 2,000. That contract would then be worth $100,000, allowing you a modest profit that gets more modest after transaction fees.

If, however, the S&P 500 has fallen in the ensuing five weeks, say to 1,980, that contract is now worth $99,000. Your attempt to secure a payout ended up costing you $687.50 (again, plus transaction fees),

Note that the S&P futures prices are conservative, in that they’re not too far from where the S&P 500 is currently. That’s by design. The S&P could well gain or lose 100 points over those five weeks: it’s happened countless times before. But even the most daring Wall Street speculator isn’t willing to bet on such a movement. The bulls are cautiously bullish here (likewise for the bears’ bearishness), preferring to hope for the likelihood of a small gain in the S&P 500 instead of the lower likelihood of a larger gain. There might exist some speculator who’d love to bet on the S&P making a 100-point gain (or loss), but it would be hard to find someone willing to take the other side. (For more, see: Futures Fundamentals: An Introduction.)

Predicting The Future

By looking at the prices of the futures contracts that settle on those subsequent quarterly dates, we can ascertain…well, not what the market is going to do, but what people think it’ll do, which can be an even more valuable piece of information. The December, March and June futures prices are, respectively, 7¾, 15, and 21½ points below the September price, showing that futures traders are expecting the S&P 500 to follow suit. The months-long bull market we’ve been experiencing will end, as they all do, but the consensus seems to be that rising prices will turn down sooner rather than later.

The Bottom Line

Stock index futures are an abstract investment. Essentially, you’re gambling on what a set of representative stocks is going to do. A stock index futures speculator is at least a few steps removed from investing in any tangibly productive activity. That might sound dismissive, but participants in the stock index futures market are indeed contributing something to the big picture. They’re providing liquidity and transferring risk, both of which are important to a fluid economy. And while society as a whole can benefit from futures contracts being bought and sold, the unpredictability inherent in the stock index futures market can and does wipe out individual participants. A good start might be trying your hand at paper trading to get a hang of it without risking anything. Either way, proceed with caution. (For more, see: Tips For Getting Into Futures Trading.)

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