What are Index Futures
Index futures are futures contracts on a stock or financial index. For each index, there may be a different multiple for determining the price of the futures contract. For example, the S&P 500 Index is one of the most widely traded index futures contracts in the United States; stock portfolio managers who want to hedge risk over a certain period of time often use S&P 500 futures. It is also used for speculative reasons, to bet on the direction of index. The value of a S&P 500 futures contract is $250 x S&P 500 index value.
Breaking Down Index Futures
Index futures are based on an underlying index. An index tracks the price of an asset or group of assets. For example, there are gold stock indexes, which track the general movement of gold-related stocks. The S&P 500 index tracks the price movements of the stocks of the largest 500 companies in the U.S. The underlying asset associated with an index future cannot generally be traded directly. For example, to replicate the S&P 500 index a trader would need to buy 500 different stocks. Or, they could simply buy an index future to create the same effect in their portfolio. Therefore, futures are the main way indexes are traded. They function and are traded in the same way as other investments on the futures market.
Hedging and Speculating
If a portfolio manager has a large number of stocks in their portfolio, they can hedge their exposure by selling index futures. Since most stocks tend to move in the same general direction, the portfolio manager could short an index futures contract if they believe stocks could fall. While the stocks they own would fall in value, the short index futures contracts would gain value as the stocks fall, offsetting the loss on the stocks. The manager could offset the entire risk of a portfolio, or only partially offset it.
The downside of hedging is that hedging will reduce profits if the hedging isn't required. For example, if the market continues to rise in the above example, by hedging the portfolio manager is worse off because they will now be losing money on the short index futures.
Index futures are also used for speculation. Instead of buying individual stocks or assets, a trader can gain access to the direction of a group of assets by buying or selling an index future. Profits are determined by the price at which the trader enters and exits the contract. For example, the value of the S&P 500 index future is $250 multiplied by the index value. If a trader buys the index at 2000, that contract has a value of $500,000. If the index falls to 1900, that contract is now only worth $475,000, a $25,000 loss. If the index increases to 2100, it is worth $525,000.
Futures contract don't require the investor to put up the entire value of the contract when entering a trade ($500,000 in this case). Rather, the trader is only required to have a fraction of that in their account, called the initial margin.
Popular Index Futures
Within the United States, some of the most popular index futures are based on equities, such as the E-Mini S&P 500 (ES), E-Mini NASDAQ 100 (NQ), and E-Mini Dow (YM).
Index futures are also available in foreign markets. These include the DAX and the SMI index futures in Europe, and the Hang Seng Index future in Asia.
Index Futures Contracts
An index futures contract states that the holder agrees to purchase an index at a particular price on a specified date in the future. If on that future date the price of the index is higher than the agreed-upon price in the contract, the holder has made a profit, and the seller suffers a loss. If the opposite is true, the holder suffers a loss, and the seller makes a profit. The price is constantly moving until the contract expires. Therefore, the trader must have enough money in their account to cover the potential loss, if applicable. This is called maintenance margin.
Futures contracts are legally binding agreements between the buyer and seller. Futures differ from an option in that a futures contract is considered an obligation, while an option is considered a right that may or may not be exercised.