Index futures are agreements whose value is derived from a financial index. Essentially, they are agreements to trade the value of an index at a future time, reflecting expectations of the index's future direction in price. Originally intended for institutional investors, index futures are open to individual investors. Traders can use these contracts to speculate on the price direction indexes, such as the S&P 500 and the Dow Jones Industrial Average (DJIA). Popular futures include fractional index futures that trade at lower prices than those aimed at institutional investors, like the Chicago Mercantile Exchange's (CME) E-mini S&P 500. Investors also use index futures to hedge their equity positions against potential losses.
Key Takeaways
- Index futures are contracts to buy or sell a financial index at a set price today and are settled in the future.
- These contracts were initially meant only for institutional investors but have been open for decades to anyone.
- 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.
- 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.
Understanding Index Futures
An index tracks the price of an asset or a group of assets, such as equities, commodities, and currencies. A futures contract is a derivative that obligates traders to buy or sell the underlying asset on a set day at a predetermined price. Putting these together, an index future is a legal contract that obligates traders to buy or sell a contract derived from a stock market index by a specific date at a predetermined price.
Index futures, which are also called stock or equity market index futures, work just like other futures contracts. They give investors the power and obligation to deliver the contract's cash value based on an underlying index on a specified date at an agreed-upon price. Unless the contract is unwound before expiration through an offsetting trade, the trader is obligated to deliver the cash value on expiry. This differs from other types of futures, like those involving commodities, where a party might be obligated to hand over the underlying asset at expiry, not cash.
Traders use index futures to hedge or speculate against future price changes in the underlying equity index. For example, the S&P 500 tracks the stock prices of 500 of the largest companies traded in the U.S. An investor could trade index futures on the S&P 500 to hedge or speculate on gains or losses of the index.
Index futures do not predict future index performance.
Types of Index Futures
The most popular index futures are based on equities, which means investors hedge their bets on the individual index named in the contract.
For instance, traders can invest in the S&P 500 index by purchasing E-mini S&P 500 futures contracts. Investors can also trade futures for the Dow Jones Industrial Average and Nasdaq 100 Index, as well as their more accessible versions, the E-mini Dow and E-mini Nasdaq-100 futures, and their even smaller variants, the Micro E-mini Dow and Micro E-mini Nasdaq-100.
Outside the U.S., there are futures available for the DAX Stock Index, which comprises 30 major German companies, and the Swiss Market Index; both of these futures trade on the Eurex. In Hong Kong, Hang Seng Index futures allow traders to speculate on that market's major index.
Index futures may use different multiples to determine the contract price. For example, the E-mini S&P 500 futures contract, which trades on the CME, has a value of $50 times the value of the index. So if the index trades at 3,400 points, the market value of the contract would be 3,400 x $50 or $170,000.
Aside from the more conventional futures contracts that derive their value from the fluctuations in prices of financial instruments, there are index event futures, which depend on expectations for a specific index. Events covered by these kinds of futures can range from electoral results (illegal except for research purposes in the U.S.) to shifts in equities and commodity prices, as well as specific indexes. An event futures contract has a binary outcome: it culminates at a predetermined value and resolves at zero if the anticipated event fails to occur. The CME began offering events futures in 2022 with daily expiries, expanding them to include quarterly and annual expirations in 2024. A typical index future might be, "Will E-mini S&P 500 Daily close above [a given point value, like 5,000 points]?" You would get a certain return if you bet on yes and another return based on no, if it turns out you were correct and depending on how others in the market are feeling about that outcome.
In 2022, the Chicago Mercantile Exchange began offering index event futures, which require you to choose yes or no to whether an index will go above a certain level, paying out if you're right and leaving you with nothing if you're wrong.
Index Futures and Margins
Futures contracts don't require the buyer to put up the entire value of the contract when entering a trade. Instead, buyers must keep just a fraction of the contract amount in their account. This is called the initial margin.
Index futures prices can fluctuate significantly until the contract expires. As such, traders must have enough money in their accounts to cover a potential loss, which is called the maintenance margin.This sets the minimum amount of funds an account must hold to satisfy future claims.
The Financial Industry Regulatory Authority requires a minimum of 25% of the total trade value as the minimum account balance, although some brokerages ask for more. As the value of the trade climbs before expiration, the broker can require that more funds be added to the account. This is called a margin call.
It's important to note that index futures contracts are legally binding agreementsbetween the buyer and seller. Futures differfrom options since futures come with an obligation. An option, meanwhile, is a right the holder may or may not exercise.
Profits and Losses from Index Futures
An index futures contract states the holder agrees to purchase an index at a particular price on a specified date. Index futures typically settle quarterly in March, June, September, and December. There are usually several annual contracts as well.
Equity index futures are cash-settled. This means there will be no delivery of the underlying asset at the end of the contract. If the index price is higher than the agreed-upon contract price at the expiry date, the buyer makes a profit while the seller (known as the future's writer) suffers a loss. In the reverse scenario, the buyer suffers a loss while the seller makes a profit.
For example, if the DJIA closes at 16,000 at the end of September, the holder with a September futures contract one year earlier at 15,760 reaps a profit.
The difference between the entry and exit prices of the contract determines profits. As with any speculative trade, there are risks the market could move against the position. The trading account must meet margin requirements and could receive a margin call to cover any risk of further losses. The trader must understand that many factors can drive market index prices, including macroeconomic conditions such as economic growth and corporate earnings.
Index Futures for Hedging
Portfolio managers often buy equity index futures as a hedge against potential losses. If the manager has positions in many 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 managercould sell or shortan index futures contract if stock prices decline. If there's a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain, offsetting the losses from the stocks.
The fund managercould hedge all the downside risks of the portfolio or only partially offset them. The downside of hedging is that this reduces profits if the hedgeisn't required. So, if an investor with a September futures contract shorts index futures and the market rises, the index futures would fall in value. The losses from the hedge would offset gains in the portfolio as the stock market rises.
Index Futures for Speculating
Speculation is a sophisticated trading strategy not suited for many investors. Experienced traders tend to 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 and properly weighing the 500 stocks in the S&P 500.
Pros and Cons of Using Index Futures
Pros
Index futures can hedge against declines in similar holdings
Brokerage accounts require only a fraction of the contract's value held as a margin
Index futures allow for speculation on changes in the index's value
Helps businesses prepare for potential changes in the wider market that would affect their bottom line
Cons
Unnecessary or wrongly directed hedges will curtail portfolio gains
Brokers may demand additional funds to maintain the account's margin amount
Index futures speculation is high risk
Unforeseen events may cause the index to move in the opposite direction
Index Futures vs. Commodities Futures Contracts
By their nature, stock index futures work differently from commodity futures. The latter allow traders to buy or sell a specified amount of a commodity at an agreed-upon price on an agreed-upon date in the future. Contracts are usually exchanged for tangible goods such as cotton, soybeans, sugar, crude oil, gold, etc.
Investors generally trade commodity futures to hedge or speculate on the price of the underlying commodity. Unlike index futures, which are cash-settled, long-position holders of commodity futures contracts will need to take physical delivery if the position has not been closed out ahead of expiry.
Businesses frequently use commodity futures to lock in prices for the raw materials they need for production.
Examples of Index Futures
Let's say you decide to speculate on the S&P 500. The E-mini S&P 500 futures are priced at $50 multiplied by the index value. So, you might buy a futures contract when it's trading at 5,000 points, resulting in a contract value of $250,000 ($50 x 5,000).
Because index futures don't require investors to put up the full 100%, you need only to maintain a small percentage in your brokerage account.
- Scenario 1: The S&P 500 Index falls to 4,900 points. The futures contract is now worth $245,000 ($50 x 4,900). You lose $5,000.
- Scenario 2: The S&P 500 Index rises to 5,100 points. The futures contract is now worth $255,000 ($50 x 5,100). You get a $5,000 profit.
How Do You Trade Index Futures?
You must open an account with a brokerage firm to trade index futures. Once your account is open, choose the index you want to trade and decide whether to go long (you believe the price will increase) or short (you think the price will decrease). Keep an eye on your contract as it nears the expiration date.
Can Index Futures Be Used to Predict Market Performance?
Index futures are generally considered an educated wager—not a predictor. Traders who invest in equity index futures speculate on the index moving in a particular direction. Investors who take long positions speculate that the index's price will increase, while those who take short positions bet that the price will drop. Various factors can move markets, which means they can go in any direction, though some directions are more likely than others. As such, the market has no fail-safe predictors, including index futures. Only enter into futures once you've gained ample experience in the market, and never invest more than you can afford to lose.
Is Index Futures Trading Riskier Than Stock Trading?
Index futures trading can be riskier than stock trading, especially when leverage is involved, which can amplify both gains and losses. While index futures offer diversification since they're based on a broad market index, their volatility and the potential for rapid financial changes heighten the risk. In contrast, stock trading allows investors to avoid inherent leverage, limiting losses to the invested amount. Hedging with futures, meant to offset risks in part of a portfolio, could lower your overall risk. Still, results can vary significantly based on market knowledge, experience, and the ability to manage leverage and diversification effectively.
How Are Index Futures Priced?
The price of index futures tracks the value of the underlying index but won't be precisely the same as it. Things that impact the price of a futures contract include how much time remains until the contract expires, the date, the current value of the index, and the interest rate charged by the broker.
How Long Can I Hold a Futures Contract?
Futures contracts have an expiration date. When the contract expires, the buyer of the contract pays the agreed-upon price for the underlying asset, and the seller must deliver it. If you own a futures contract, you may hold it for as long as you'd like up to the expiry. Investors can often roll over the contract to the next month to avoid the costs related to settling the futures contract.
The Bottom Line
Index futures contracts allow investors to make trades on various indices based on their predictions about the overall price movement of the particular index. Futures contracts involve margin, meaning investors can trade much larger amounts of money than their actual available capital. Before trading futures, ensure you understand how they work and that you can handle the volatility and potential losses they involve. While futures trading has expanded dramatically in the past decade or so, it's still often a losing bet for inexperienced traders.
