What is a Stock Index Future?
Stock index futures, also referred to as equity index futures or just index futures, are futures contracts based on a stock index. Futures contracts are an agreement to buy or sell the value of the underlying asset at a specific price on a specific date. In this case, the underlying asset is tied to a stock index.
Index futures, however, are not delivered at the expiration date. They are settled in cash on a daily basis, which means that investors and traders pay or collect the difference in value daily. Index futures can be used for a few reasons, often by traders speculating on how the index or market will move, or by investors looking to hedge their position against potential future losses.
Quick Summary of Points
- Stock index futures are a purely cash-settled futures contract based on a stock index
- Index futures are settled daily and traded by futures brokers on stock exchanges
- Index futures are used for a number of reasons such as speculating, hedging, and spread trading
- Index futures can be used as strong leading indicators of market sentiment
How are Stock Index Futures Traded and Settled?
Stock index futures are similar to other futures contracts; however, the underlying asset is a stock index. With any futures contract, there is the agreement to pay a specific price on a set date (the expiration date). Index futures are purely cash-settled since it is not possible to physically deliver an index, and the settlements happen daily, on a mark-to-market basis.
Index futures are traded through futures brokers on stock exchanges, and a futures contract can be made through a buy or sell order. A long position is taken when a buy order is initiated, and a short position is initiated through a sell order. Like other futures contracts, a minimum amount, known as the initial margin is required to take the position. A maintenance margin is also set, meaning the value must not drop past a certain point or else a margin call will be initiated. A trader will then need to deposit funds to meet this margin.
What are Stock Index Futures Used For?
Stock index futures are used for a number of reasons. The most common reason is from traders who are speculating on the direction the market will move in the future. Similarly to speculation on other assets, if a trader takes a bullish stance on the market and believes that the index will increase in value, then they may buy the stock index futures. Alternatively, if they have a bearish stance on the market the index is focused on, they may short the index futures contract.
The assessment of index futures can be an important leading indicator of market sentiment. A high volume of long positions being taken on an index could mean that many traders are bullish on the market and believe the market the index is based on will increase in value.
Index futures can also be used for hedging purposes. If an investor is holding a portfolio that is similar or reflective of an index, buying or selling index futures can be used to offset potential losses their portfolio may face. In most cases, the portfolio will not be fully positively or negatively correlated with the index, so using index futures will not lead to a fully hedged position.
One other way index futures are used is as a spread or relative value trading tool. This is a position that involves taking a long and short position on index futures. This trade is done with a focus on the spread or the difference in the prices of the related securities. The trade will attempt to net a profit from the widening or narrowing of these prices, rather than a change of the index as a whole.
What are Some Widely Traded Stock Index Futures?
Index futures are traded for all major stock indices. They include the Dow Jones, S&P, Nasdaq, FTSE, DAX, and the many other stock indices that exist. There are also index futures that exist to increase accessibility by requiring less capital.
For example, the E-Mini S&P is an index futures contract traded on the Chicago Mercantile Exchange’s Globex platform and uses the S&P 500 as an underlying asset. It was introduced in 1997 when the S&P contract at the time was 500 times the index. The amount was too much for many traders, so the E-Mini S&P was introduced. The index futures contract is only 50 times the value of the S&P 500.
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