A:

S&P 500 futures are a type of capital asset contract that provides a buyer the right to a predetermined selection of stocks and on a predetermined future date listed on the S&P 500 stock market index. There are different sizes of stock baskets for the S&P 500; the Chicago Mercantile Exchange, or CME, offers a "big contract" and an "e-mini" contract.

Introduction to S&P 500 Futures

The first S&P 500 futures contracts were introduced by the CME in 1982. The CME added the e-mini option in 1997. The bundle of stocks in the S&P 500 is, fittingly, comprised of 500 different large companies.

The big futures contract was originally priced by multiplying the quoted futures price by $500. For example, if the S&P was trading at $800, the value of the big contract was $400,000, or $500 x $800. Eventually, the CME cut the contract multiplier in half to $250 times the price of the futures index.

E-mini futures are one-tenth the value of the big contract. If the S&P 500 futures price is $800, this results in an e-mini being valued at $40,000. The "e" in e-mini stands for electronic.

Like with all futures, investors are only required to front a fraction of the contract value to take a position. This represents the margin on the futures contract. These margins are not the same as margins for stock trading; futures margins show "skin in the game," which must be offset or settled.

Cash Settlement of S&P 500 Futures

Industry experts created the cash settlement mechanism to resolve the massive logistical challenges presented by delivering the actual 500 stocks associated with a futures contract. Not only would the stocks have to be negotiated and transferred between holders, but they would have to be properly weighted to match their representation in the index. Instead, an investor picks a long or short position, which is then subject to a mark-to-market; the investor pays any losses or receives profits each day in cash. Eventually, the contract expires, or is offset, and becomes cash settled based on the spot value of the S&P 500 index.

Instant Portfolio Diversification

One of the oft-proclaimed benefits of trading S&P 500 futures is each contract represents an immediate indirect investment into 500 different stocks. This, like all diversification, helps mitigate exposure to unsystematic risk.

There is a downside as well; the S&P 500 tracks very well with systematic fluctuations. Investors cannot rely on the S&P 500 futures contract to hedge most other equities. Additionally, these futures run the risk of over-diversification. Investors looking to beat the market average are ill-advised to rely heavily on market index instruments.

Other Options

In addition to basic futures contracts, the CME has variations of the S&P 500 futures, including options. Some asset managers use covered call writing techniques by selling call options against the S&P 500 equity portfolio.

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