Stock index futures are futures contracts that have an underlying value, tied to a stock index. Some of the more popular ones are S&P 500 futures, Dow Jones 30 futures, Nasdaq 100 futures, and Russell 2000 futures. Understanding how these instruments work and why they are important, can help stock market participants become more successful investors and/or traders.
Before understanding stock index futures, one must understand what a futures contract is. Futures contracts are agreements for the settlement of some type of asset in the future.
A different type of financial instrument, forward contracts, is also an agreement to exchange assets in the future. The key differences between futures and forwards is that futures trade on exchange and are for a set amount of a particular asset at a set date. For example, S&P 500 futures trade at the Chicago Mercantile Exchange. The value is derived by multiplying the value of the S&P 500 by $250. So, if the S&P 500 is at 3,300, the settlement value December 2020 S&P 500 futures would be $825,000 on December 18th. Forward contracts, on the other hand, can be negotiated privately, for any amount, and for any settlement date. Because they are homogeneous, futures can be entered into and sold very easily. This is called liquidity.
Another feature that differentiates futures from forward contracts, is that gains or losses are settled daily for futures contracts. This process is called marking to market, or marked to market. Forward contracts are not necessarily marked to market, but they can be. Because of this and the fact that futures are cleared through an exchange, the risk that a counterparty will default on the contract, or counterparty risk, is considered to be less for futures contracts than that of forward contracts.
A person or institution who wishes to get involved in futures, must first open up a brokerage account. Then, they are required to deposit a certain amount of cash or short term investment vehicle, with the clearing broker. This deposit is called margin. Margin may vary, based on the volatility of the underlying asset, liquidity and other variables. If the mark to market value goes down to a certain level, the margin accounts funds must be replenished. This is called a margin call and the cash value level this happens at is called the maintenance margin.
Futures also serve as an indicator of what the price of an asset will be in the future. Almost like an instant “vote” on what the price will be. Futures can also be used as vehicles to hedge against lower prices, if the underlying is owned or higher prices, if the asset is set to be purchased.
If you are a large institution, with specific needs, you may wish to negotiate a forward contract, with a financial intermediary. However, most people or institutions that want to speculate on an assets price in the future, will opt to trade futures.
Stock index futures are futures contracts that settle based on a stock index. The stock index is called the underlying asset. We discussed S&P 500 index futures above. That is a stock index future contract.
As noted above, the S&P 500 index futures are settled by taking the value of the index and multiplying it by 250. There are also E Mini S&P 500 index futures, which are 50 times the underlying value. Dow Jones Industrial futures are 10 times the index price and Dow Jones Industrial Mini futures are 5 times the index price.
Stock index futures have many uses. A good example is if a person or institution is scheduled to receive funds to invest at a certain date, but wants to put them to use right away. They could buy stock index futures, with an underlying value, similar to the funds they will receive.
Another example is if a person feels the stock market will go down, but does not think it is going to stay down for a long time. That person may sell stock index futures, against the stocks they already own. Effectively, hedging themselves against losses
Stock index futures utilize leverage. This is because the margin amount that needs to be deposited is far less than the value of the contract. This makes them very useful, when implementing the examples highlighted above. When purely speculating, it enhances gains, but also magnifies losses. The short is, be very careful when taking a position in any futures contract.