A futures contract represents a legally binding agreement between two parties. In the contract, one party agrees to pay the other the difference in price from the time they entered the contract until the date the contract expires. Futures trade on exchanges and allow traders to lock in prices of the underlying commodity or asset named in the contract. Both parties are aware of the expiration date and prices of these contracts, which are generally set up front.
Contracts carry a multiplier that inflates its value, adding leverage to the position. This can be traded on the long or short side without restrictions or uptick rules. There are many different types of futures contracts including those that deal with equities, commodities, currencies, and indexes. In this article, we explain the basics of index futures contracts and what they represent.
- Like a regular futures contract, an index futures contract is a legally binding agreement between a buyer and a seller, and tracks the prices of stocks in the underlying index.
- It allows traders to buy or sell a contract on a financial index and settle it at a future date.
- The S&P 500, Dow, and Nasdaq index futures contracts trade on the CME Globex system, and are called e-mini contracts.
- Index futures contracts are marked to market, meaning the change in value to the contract buyer is shown in the brokerage account at the end of each daily settlement until expiration.
Index Futures Contracts
Like a regular futures contract, an index futures contract is a legally binding agreement between a buyer and a seller. It allows traders to buy or sell a contract on a financial index and settle it at a future date. An index futures contract speculates on where prices move for indexes like the S&P 500.
As futures contracts track the price of the underlying asset, index futures track the prices of stocks in the underlying index. In other words, the S&P 500 index tracks the stock prices of 500 of the largest U.S. companies. Similarly, Dow and Nasdaq index futures contracts track the prices of their respective stocks. All of these index futures trade on exchanges.
The index futures contract mirrors the underlying cash index, and acts as a precursor for price action on the stock exchange where the index is used. Index futures contracts trade continuously throughout the market week, except for a 30-minute settlement period in the late afternoon U.S. central time, after stock markets close.
The S&P 500, Dow, and Nasdaq index futures contracts trade on the CME Globex system—a 24-hour electronic marketplace—and are called e-mini contracts. The S&P 500 also trades a larger-sized contract on CME's open outcry system, but it attracts little volume compared to the electronic markets. Contracts are updated four times per year, with expiration taking place during the third month of each quarter.
E-mini futures contracts trade from Sunday evening through Friday afternoon, offering traders nearly continuous market access during the business week. Liquidity tends to dry up between the U.S. equity market close and the opening of the European stock exchanges in the early morning hours. Spreads and volatility can widen during these periods, adds significant transaction costs to new positions.
E-mini futures contracts trade from Sunday evening through Friday afternoon in the United States.
If the e-mini S&P 500 futures contract trades higher before the opening of U.S. stock markets, it means the S&P 500 cash index will trade higher following the opening bell. Contracts track U.S. index direction closely during regular stock market trading hours, but will be priced higher or lower because they represent expected future prices rather than current prices. Contracts denote approximate valuations for the next trading day when U.S. markets are closed, based on perceptions about overnight events and economic data, as well as movements in correlated or inversely-correlated financial instruments that include the forex markets—which also trades nearly 24 hours per day.
The contract multiplier calculates the value of each point of price movement. The e-mini Dow multiplier is 5, meaning each Dow point is worth $5 per contract. The e-mini Nasdaq multiplier is 20, worth $20 per point, while the e-mini SP-500 carries a 50 multiplier that's worth $50 per point.. For example, if an e-mini Dow futures contract is valued at $10,000 and a buyer picks up one contract, it will be worth $50,000. If the Dow then falls 100 points, the buyer will lose $500 while a short seller will gain $500.
Index futures contracts are marked to market, meaning the change in value to the contract buyer is shown in the brokerage account at the end of each daily settlement until expiration. For example, if the e-mini Dow contract drops 100 points in a single trading day, $500 will be taken out of the contract buyer's account and placed into the short seller's account at settlement.