What is a Stock Index Future?
Index futures are futures contracts allowing traders to purchase or sell a contract based on a financial index’s value today that will be paid later. Initially designed for institutional investors, they are now available to individual investors.
They are financial contracts that offer you the right and the duty to purchase or sell stock market indices at a predetermined price at a future date.
You may trade futures for the S&P 500, Dow Jones, and Nasdaq 100 indices and overseas market indexes, including the FTSE 100 and Hang Seng.
Traders utilize these contracts to bet on the direction of price indexes like the S&P 500 and theDow Jones Industrial Average(DJIA). They also employ these contracts to protect themselves against losses in their securities.
The price of assets or collection of assets, such as shares, commodities, and currencies, is tracked by an index. Afutures contractis a derivative form in which traders must purchase or sell the underlying asset at a fixed price on a specific day.
As a result, an index future is a legal contract that binds traders to purchase or sell a contract generated from a stock market index at a specified price by a specific date. Index futures, often known as stock or equity market index futures, work the same way as any other futures contract.
They offer investors the authority and responsibility to deliver the contract's cash value based on an underlying index for a predetermined price at a predetermined future date.
The trader is bound to provide the cash value on expiry unless an offsetting deal before expiration unwinds the contract. Traders use these contracts to protect themselves against future price movements in the underlying equities index.
The S&P 500 Index, for example, follows the stock prices of 500 of the largest publicly listed firms in the United States. To hedge or speculate on the index's gains or losses, an investor might purchase or sell the futures contracts on the S&P 500.
Understanding Stock Index Futures
The futures contract holder agrees to buy an index at a specific price on a particular date in the future. These contracts usually settle in March, June, September, and December. In most cases, there are numerous yearly contracts.
Futures on equity indexes are paid in cash, signifying that the underlying asset will not be delivered after the contract.
The buyer gets a profit if the index price at the expiry date exceeds the agreed-upon contract price, while the seller (known as the future writer) loses money. In the opposite situation, the customer loses money while the seller profits.
Suppose the Dow finishes at $16,000 at the end of September, the holder of a September futures contract with a forward price of $15,760 makes a profit.
The profit margin is calculated by the difference between the contract's entry and exit prices. Of course, as with any speculative deal, there is the possibility that the market will move against the trader.
As previously stated, the trading account must fulfill margin requirements and may be subject to a margin call to cover any additional losses.
Market index prices are influenced by various variables, including macroeconomic conditions, economic growth, and business profitability.
Stock Index Future Pros and Cons
Let's take a look at some of the pros and cons below.
Some of the pros include:
- They can protect you from losses in related investments.
- Only a tiny portion of the contract's value must be retained as a margin in brokerage accounts.
- They allow for speculation on the fluctuation of an index's price.
- Assists firms in locking in commodities futures pricing.
On the other hand, the cons are:
- Unnecessary or incorrect direction hedges may harm any portfolio gains.
- Brokers can demand more cash to keep the account's margin.
- Trading these contracts is a high-risk endeavor.
- Unexpected events may lead the index to move in an unanticipated direction.
What are Some Widely Traded Stock Index Futures?
Some of the most popular index futures are based on stocks, allowing investors to hedge their bets on the specific index specified in the contract.
The E-Mini S&P, for example, is a futures contract that utilizes the S&P 500 as an underlying asset and is traded on the Chicago Mercantile Exchange's Globex platform. It was first offered in 1997, at a period when the S&P contract was 500 times the index.
The E-Mini S&P was created because the sum was too large for many traders. As a result, the E-mini contract is merely 50 times the value of the futures contract.
The DAX Stock Index, comprising 30 top German corporations, and the Swiss Market Index, which trades on Eurex, have futures accessible outside the United States.
The Hang Seng Index (HSI) futures market in Hong Kong allows traders to bet on the market's key index.
Various multiples may be used to establish the contract price for different products. For example, the E-mini S&P 500 futures contract trades on theChicago Mercantile Exchange(CME) and is worth 50 times the index's value. If the index trades at 3,400 points, the contract's market value is 3,400 x $50, or $170,000.
What are Stock Index Futures Used For?
Futures on stock indexes are utilized for a variety of purposes. Traders betting on which way the market will move in the future are the most typical cause. For example, if a trader has an optimistic perspective on the market and feels the index will rise in value, they can buy stock index futures, just like they do with other assets.
Alternatively, they might short the futures contract if they are pessimistic about the market the index is tracking. The evaluations given by these futures can be a useful leading predictor of market mood.
Many long bets on an index might indicate that many traders are optimistic about the market and anticipate the index's underlying demand will rise in value.
Hedging with them is also an option. If an investor has a portfolio comparable to or reflective of an index, futures can be utilized to mitigate any possible losses in the portfolio.
Because the portfolio is unlikely to be positively or negatively linked with the index in most situations, employing index futures will not result in a fully hedged position.
They may also be utilized as a spread or relative value trading tool. This is a trade that entails taking both long and short positions. This trade focuses on the associated securities' spread or price differential.
The trade will try to benefit from the widening or narrowing these prices.
How Are Stock Index Futures Traded and Settled?
Stock index futures are comparable to other futures contracts, except they have a stock index as their underlying asset.
There is an agreement to pay a specified price on a specific date with each futures contract (the expiration date). They are entirely cash-settled because an index cannot be physically delivered, and settlements are made daily on a mark-to-market basis.
These futures are traded on stock exchanges through futures brokers, and a futures contract can be created with a buy or sell order.
When a purchase order is placed, a long position is taken, and when a sell order is placed, a short position is taken. A minimum amount known as the initial margin is necessary to take the position, like other futures contracts.
A maintenance margin is also established, implying that the value must not go below a specific level, or a margin call would be issued. To meet this margin, a trader must deposit money, or the position will be closed.
What is Speculation? It is a sophisticated trading method that is not appropriate for most investors. Experienced traders, on the other hand, prefer to bet on the direction of an index using futures.
Rather than buying individual stocks or assets, a trader can buy or sell futures to wager on the direction of a collection of assets.
To duplicate the S&P 500 Index, for example, investors would have to purchase all 500 equities in the index.
On the other hand, these futures may be used to wager on the direction of all 500 stocks, with one contract having the same effect as owning all 500 stocks in the S&P 500.
Managing Risk with Stock Index Futures
We can manage risk with the use of margins in stock index futures trading. The different types of margins and hedging are:
1. Index Futures and Margins
The buyer does not have to put up the whole contract amount when buying a futures contract. Instead, the buyer is just required to keep a percentage of the contract amount in their account. It is called the first margin.
Price fluctuations in index futures can be significant until the contract expires. As a result, traders must have sufficient funds in their accounts to cover a potential loss, known as the maintenance margin.
The maintenance margin specifies the minimum amount of cash that must be held in an account to cover future demands.
The Financial Industry Regulatory Authority (FINRA) demands a minimum account balance of 25% of the entire deal value, while some brokerages may need a higher percentage.
If the position's value declines before it expires, the broker might demand that more money be placed into the account. It is referred to as a margin call.
These futures contracts are legally binding agreements between the buyer and seller. Because a futures contract is considered an obligation, it differs from an option. An option, on the other hand, is a right that the holder can exercise or not.
2. Index Futures for Hedging
Portfolio managers frequently purchase equity index futures as a hedge against probable losses. If the manager has a significant number of stock investments, selling them might assist in mitigating the risk of falling stock prices.
If stock prices fall, the portfolio manager might sell or short them because equities in the same market, industry, etc., tend to move in the same general direction.
The stocks in the portfolio would lose value in the case of a market downturn, while the sold index futures contracts would gain weight, offsetting the stock losses.
The fund's management might either fully or partially hedge the portfolio's harmful risks. Hedging has the disadvantage of reducing profits if the hedge is not necessary.
So, if the investor from the previous example shorts these futures in September and the market rises, they will lose value. As the stock market increases, the hedge's losses balance the portfolio's gains.
Researched and authored by Tanay Gehi | Linkedin
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