Index Futures

What Are Index Futures?

Index futures are futures contracts whereby a trader can buy or sell a financial index today to be settled at a future date. Traders use index futures to speculate on the price direction of 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 Explained

Index futures, like all futures contracts, give the trader or investor the power and obligation to deliver the cash value of the contract based on an underlying index at a specified future date. Unless the contract is unwound before expiration through an offsetting trade, the trader is obligated to deliver the cash value on 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 traded in the United States. An investor could buy or sell index futures on the S&P 500 to speculate on 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. For example, the S&P 500 futures contract is priced at $250 times the level of the S&P 500, so if the index trades at 3,400 points, then the market value of the contract would be 3,400 x $250 or $850,000. The E-mini S&P 500 futures contract has a value of $50 times the value of the index. If the index traded at 3,400 points, the market value of the contract would be 3,400 x $50 or $170,000.

Investors can also trade futures for the Dow Jones Industrial Average (DJIA) and Nasdaq 100 Index. There are the E-mini Dow and E-mini Nasdaq-100 futures contracts, or their smaller variants the Micro E-mini Dow and Micro E-mini Nasdaq-100.

Outside of the U.S., there are futures available for the DAX Stock Index of 30 major German companies and the Swiss Market Index (SMI), both of which trade on the Eurex. In Hong Kong, Hang Seng Index (HSI) futures allow traders to speculate on that market's major index.

Margin and Index Futures

Futures contracts don't require the buyer to put up the entire value of the contract when entering a trade. Instead, they only require 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 maintenance margin. Maintenance margin sets the minimum amount of funds an account must hold to satisfy any future claims.

The Financial Industry Regulatory Authority (FINRA) requires a minimum of 25% of the total trade value as the minimum account balance. However, some brokerages will demand greater than 25%. Also, as the value of the trade climbs before expiration, the broker can demand additional funds be deposited into 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 the holder may or may not exercise.

Profits and Loss from Index Futures

An index futures contract states the holder agrees to purchase an index at a particular price on a specified future date. Index futures are 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 contract price, the buyer has made a profit, and the seller — the 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 futures contact one year earlier at 15,760 would reap 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 the market could move against the position. As mentioned earlier, the trading account must meet margin requirements and could receive a margin call to cover any risk of further losses. Also, the 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 this reduces profits if the hedge isn't required. Take for example the above scenario. If the portfolio manager shorts 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 purchasing 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 500.

Index Futures Vs. Commodities Futures Contracts

By their nature, stock index futures operate differently than futures contracts for tangible goods such as cotton, soybeans or crude oil. Long position holders of commodities futures contracts will need to take physical delivery if the position has not been closed out ahead of expiry.

Businesses will frequently use commodity futures to lock in prices for the raw materials they need for production.

Examples of Index Futures Speculating

An investor decides to speculate on the S&P 500. Index futures for the S&P 500 are priced at $250 multiplied by the index value. The investor buys the futures contract when the index trades at 2,000 points, resulting in a contract value of $500,000 ($250 x 2,000). Because index futures contracts don't require the investor to put up the full 100%, they need only to maintain a small percentage in a brokerage account.

Scenario 1

The S&P 500 Index falls to 1,900 points. The futures contract is now worth $475,000 ($250 x 1,900). The investor has lost $25,000.

Scenario 2

The S&P 500 Index rises to 2,100 points. The futures contract is now worth $525,000 ($250 x 2,100). The investor has earned a $25,000 profit.