If a security trades publicly, then there exists a derivative or other second-order byproduct of it. Put options, REITs, rainbows and more; all of them are contingent on an underlying stock, or real estate, or even multiple stocks, or something beyond. Thus it goes with futures, in which you’re betting on whether a commodity will rise or fall in price by a certain date. (Although no one in the market is gauche enough to call it “betting.” The preferred term of art is “transferring risk.”) The commodity in question can be perishable (e.g. cattle, wheat) or not (silver, platinum). It can even be intangible. 

Take the Dow Jones Industrial Average, or the S&P 500. A stock market index is, at its essence, just a number that represents a collection of stock prices manipulated arithmetically. The index is a quantity, but not really “of” anything you can taste or touch. Yet we can add another level of abstraction and create a futures contract for a stock index, the result of which is speculators taking positions on what direction the market at large will move in. In other words, buying and/or selling a number. A number of great cultural and perceived significance, but still, ultimately a number.

Here’s an example. Futures contracts exist for the Dow, and they settle at the end of the quarter. On October 15, 2014, the Dow closed at 16,141.74. (Even with several of its components trading at over $100, for some reason the index is still quoted to two decimal places.) The next four upcoming closing dates for futures are therefore December 2014, March 2015, June 2015 and September 2015.

As of this writing we’re in something of a chronologically localized bear market, with the Dow at its lowest level since April and 7% off its all-time zenith of a month ago. The Dow index futures reflect the general pessimism, the price for a contract closing in December 2014 currently trading at 16,049. The gloominess continues into 2015: the remaining subsequent futures are trading at 15,936; 15,850; and 15,760 respectively.

15,760 would clearly be a substantial loss. Will the market in point of fact lose another 2.4% of its value between now and the end of next summer? Collective wisdom says yes. Or more precisely, collective wisdom has determined that 15,760 is the point at which speculators en masse have agreed to meet. It’s much like a pointspread for a football game. Say the Buccaneers are favored to beat the Jets by 3 next week. That number need not be an accurate representation of the teams’ relative strengths. Instead, when the Buccaneers are favored by 3 it means as much of the marketplace has committed money to the proposition saying “they will” as saying “they won’t”. Undue pessimism, or optimism, will distort the price.

More fundamentally, why indeed are the upcoming futures prices trending downward rather than trending upward? Or even just staying neutral? The usual suspects are to blame – economic uncertainty, unimpressive growth, a base level of political agitation. Throw in other negatives, no matter how incidental they are to the stock market (e.g. ISIS, Ebola) and here we are.

Superficially, stock index futures should track actual index movements. Buy an index fund that tracks the Dow, or the S&P 500, and you can expect to pay a certain price that’s directly proportional to the level of the index itself. The two fluctuate in step, or close to it. But one huge difference between stock index futures and such index funds is that the former don’t take dividends into account. An index fund, by virtue of actually holding positions in the various stocks that comprise the index, is eligible for whatever dividends those stocks’ companies’ managers decide to pay out to shareholders. An instrument as abstract as a stock index future doesn’t hold a position in the stocks that comprise the index, and thus doesn’t hold any potential for dividends.

The Bottom Line

By their nature, stock index futures operate differently than do futures contracts for more palpable securities such as cotton, soybeans or Texas light sweet oil. When the index futures contracts come due at the end of the quarter, the contract holders are delivering…well, nothing really. Just the funds to settle the contract. If the Dow were to sit at 16,000 at the end of next September, the holder who bought a September 2015 futures contact at 15,760 enjoys a modest profit. In practice, stock index futures are purchased by portfolio managers who merely want to hedge against potential losses. But whether held by a conservative fund manager, or a reckless speculator looking for an obscure new instrument to sink his teeth into, stock index futures represent an efficient method of transferring risk in a market that can be homicidally volatile at times.