What Are Index Futures?
Index futures are futures contracts where a trader can buy or sell a financial index today to be settled at a future date. Index futures are used to speculate on the direction of price movement for an index such as the S&P 500.
Investors and investment managers also use index futures to hedge their equity positions against losses.
- Index futures are contracts to buy or sell a financial index at set price today, to be settled at a date in the future.
- Portfolio managers use index futures to hedge their equity positions against a loss in stocks.
- Speculators can also use index futures to bet on the market's direction.
- Some of the most popular index futures are based on equities including the E-Mini S&P 500, E-Mini NASDAQ 100, and E-Mini Dow. International markets also have index futures listed.
Index Futures Explained
Index futures, like all future contracts, give the trader or investor the power and the commitment to deliver the cash value based on an underlying index at a specified future date. Unless the contract is unwound before the expiration through an offsetting trade, the trader is obligated to deliver the cash value on the expiry.
An index tracks the price of an asset or group of assets. Index futures are derivatives meaning they are derived from an underlying asset—the index. Traders use these products to exchange various instruments including equities, commodities, and currencies. For example, the S&P 500 index tracks the stock prices of 500 of the largest companies in the United States. An investor could buy or sell index futures on the S&P to speculate the appreciation or depreciation of the index.
Types of Index Futures
Some of the most popular index futures are based on equities. However, each product may use a different multiple for determining the price of the futures contract. As an example, the value of the S&P 500 futures contract is $250 times the S&P 500 index value. The E-mini S&P 500 futures contract has a value of 50 times the value of the index.
Index futures are also available for the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 along with E-mini Dow (YM) and E-mini NASDAQ 100 (NQ) contracts. Index futures are available for foreign markets including the German, Frankfurt Exchange traded (DAX)—which is similar to the Dow Jones—the SMI index in Europe, and the Hang Seng Index (HSI) in Hong Kong.
Margin and Index Futures
Futures contracts don't require the trader or investor to put up the entire value of the contract when entering a trade. Instead, they only required the buyer to maintain a fraction of the contract amount in their account, called the initial margin.
Prices of index futures can fluctuate significantly until the contract expires. Therefore, traders must have enough money in their account to cover a potential loss, which is called the maintenance margin. Maintenance margin sets the minimum amount of funds an account must have to satisfy any future claims.
Both the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority, Inc. (FINRA) require a minimum of 25% of the total trade value as the minimum account balance. However, some brokerages will demand greater than this 25% margin. Also, as the value of the trade climbs before expiration the broker can demand additional funds be deposited to top-off the value of the account—known as a margin call.
It's important to note that index 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 the holder may or may not exercise.
Profits and Loss from Index Futures
An index futures contract states that the holder agrees to purchase an index at a particular price on a specified future date. Index futures typically settled quarterly, and there are several annual contracts as well.
Equity index futures are cash settled meaning there's no delivery of the underlying asset at the end of the contract. If on expiry, the price of the index is higher than the agreed-upon price in the contract, the buyer has made a profit, and the seller—future writer—has suffered a loss. Should the opposite be true, the buyer suffers a loss, and the seller makes a profit.
For example, if the Dow were to close at 16,000 at the end of September, the holder who bought a September future contact one year earlier at 15,760 would have a profit.
Profits are determined by the difference between the entry and exit prices of the contract. As with any speculative trade, there are risks that the market could move against the position. As mentioned earlier, the trading account must keep funds or margin on hand and could have a margin call demand to offset any risk of further losses. Also, the investor or trader must understand that many factors can drive market index prices including macroeconomic conditions such as growth in the economy and corporate earnings or disappointments.
Index Futures for Hedging
Portfolio managers will often buy equity index futures as a hedge against potential losses. If the manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures. Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline. In the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value offsetting the losses from the stocks.
The fund manager could hedge all of the downside risks of the portfolio, or only partially offset it. The downside of hedging is that hedging can reduce profits if the hedge isn't required. For example, if in the above scenario, the portfolio manager shorts the index futures and the market rises, the index futures would decline in value. The losses from the hedge would offset gains in the portfolio as the stock market rises.
Speculation on Index Futures
Speculation is an advanced trading strategy that is not suited for many investors. However, experienced traders will use index futures to speculate on the direction of an index. Instead of buying individual stocks or assets, a trader can bet on the direction of a group of assets by buying or selling index futures. For example, to replicate the S&P 500 index, investors would need to buy all 500 stocks in the index. Instead, index futures can be used to bet on the direction of all 500 stocks with one contract creating the same effect of owning all 500 stocks in the S&P.
Portfolio managers use index futures to hedge declines in similar holdings.
Brokerage accounts required only a fraction of the contract's value held as a margin,
Index futures allows for speculation on the index price movement.
Business use commodity futures to lock in commodity prices.
Unnecessary or wrong direction hedges will damage any portfolio gains.
Brokers can demand additional funds to maintain the account's margin amount.
Index futures speculation is a high-risk undertaking
Unforeseen factors may cause the index to move opposite from the desired direction.
Index Futures Vs. Commodities Futures Contracts
By their nature, stock index futures operate differently than futures contracts for more tangible securities such as cotton, soybeans, or crude oil. Long position holders of these commodities future contracts will need to take physical delivery upon expiration if the position has not been closed out ahead of time.
Businesses will frequently use commodity futures to lock in prices for the raw material they need for production.
Examples of Index Futures Speculating
An investor decides to speculate on the direction of the S&P 500. Index futures for the S&P 500 are valued at $250 multiplied by the index value. The investor buys the futures contract when the S&P index is valued at 2,000, resulting in the contract value of $500,000 (2000 x $250). Since index futures contracts don't require the investor to put up 100% of the contract, the investor is only required to maintain a small percentage in a brokerage account.
The S&P index falls to 1900, and the futures contract is now only worth $475,000 (1900 x $250). The investor has incurred a $25,000 loss.
If the index increases to 2100, the futures contract is now worth $525,000 (2100 x $250). The investor has earned a $25,000 profit.