Last Updated on November 17, 2023
Every trader worth their salt knows about the stock futures market. Even those who are just getting started with the financial market likely have frequently heard indexes mentioned in the news. These include the S&P 500, Dow Jones Industrial Average, FTSE 100, Nikkei 225, DAX, and the CAC 40. Most people will recognize these index names at least in passing. However, it’s far more important to know how to gain exposure to them. In this guide, we discuss this market and what you need to know to trade indices.
What Are Stock Futures?
Stock futures fall under a category of futures contracts that investors use to trade stock indices. These indices bundle the shares of different companies based on specific criteria. This makes it easier to look at overall trends in the market based on the index level. That’s why stock (or equity) indices are often a suitable measure of investor sentiment in a specific market.
For example, a technology stock index tracks a bundle of technology stocks and will move with the overall performance of the stocks within it. Investors can then use this index to quickly gauge the performance of technology stocks. Either in the present or over a specific period of time.
Stock index futures have been on the investment map since their introduction in the early 1980s. The first stock index futures were launched in February 1982. Institutional traders originally used them as a hedging instrument to protect against sudden price reversals. Their use has since evolved to being used as a speculative tool among private individual day traders. They are also used as a basis to arrive at pricing for CFD index futures.
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How Are They Used to Predict Market Movements?
Stock futures exchanges like the CME typically have longer trading hours than regular exchanges. Some futures contracts are traded around the clock. This makes them useful for predicting where a stock index may move next. Alternatively, at least where speculators think an index will move by the time the underlying exchange opens for the day.
A good example is the FTSE 100 Index Futures. These futures contracts are traded from 1:00 AM to 9:00 PM London time, while the regular trading hours for the FTSE 100 market are from 8:00 AM to 5:00 PM. In this way, any news coming outside of that period about the FTSE market can influence trading sentiment before the market opens.
Stock Index Futures Contracts
Before exploring how to trade stock futures, it’s essential to understand the structure of index futures contracts. Entering into an index futures contract means both parties are bound to an agreed value for the underlying index to be settled at a specified future date. This basically means that traders have the obligation, not the right (unlike with options,) to settle the contract at a future date. The value of a stock index contract is specified by the exchange where the index is traded.
Like any derivative, stock index futures are a zero-sum game. One party takes a long position, and the other takes a short position. There’s no physical underlying asset to deliver, so index futures are always settled in cash. At the time of settlement, one trader pays the other for the difference between the agreed index futures price and the closing value of the index.
Trading Stock Futures Contracts
You can trade stock index futures through a commodity futures broker who will facilitate the trade on both buy and sell orders. Just make sure that it is a reliable platform and you can afford their margin requirements.
You can visit the National Futures Association to vet any potential brokers that you may be considering. Check their futures trading fees, complaints lodged against them, and track records in generating fair, clean stock futures trades.
Like trading traditional stock market securities, a buy order means taking a long position that profits from a rising stock index. A sell order results in a short position to realize profits from a declining index.
Stock index futures rely purely on cash settlement since there’s no possible way to physically deliver an index. The settlements also occur daily on a mark-to-market basis.
Like other futures contracts, traders must put up an initial margin to enter a position in index futures. There’s also a maintenance margin set for each contract. Traders who can’t maintain the account value the margin requires will receive a margin call. This basically means that the trade will be forced to close, or the investor will need to put up more money to get back to the broker’s margin requirement.
If the futures market seems a tad too complicated, you can also consider stock index exchange-traded funds (ETFs). These offer similar exposure as stock futures without dealing with the relatively high risk we typically associate with stand-alone stock index vehicles.
Calculating Profit or Loss in Stock Index Futures
The opening value of a futures trade is the price that you paid for the futures contract when placing the trade. The resulting profit or loss is then calculated from that value. To determine the size of your profit or loss, you’ll need to consider the number of futures contracts you traded in that session. As well as how much each contract is worth per point of movement in the index.
For example, one of the more popular indices available today is the S&P 500. Each point in a full-size S&P 500 futures contract has a fixed value of $250. Assuming the index is at a value of 2,600 points when you buy the S&P futures contract, then it will be worth $650,000 (250 x 2,600).
If you buy one contract on a 10% margin, then you need to put up $65,000 to initiate the position.
Suppose the underlying index swings 20 points. Then you have the potential to gain or lose $5,000 ($250 x 20 points) depending on which direction the index moves. You then add or subtract profit or loss on the trade from your margin deposit in your trading account.
As you can see, trading stock futures is neither for the faint-hearted nor for those with very little cash to spare. For this reason, some exchanges have developed E-mini and Micro-E-mini contracts. They let traders with smaller accounts also participate in the futures market.
Stock Index Futures Trading Strategy
If you’re new to derivatives trading, it’s best to start simple. Remember, the stock futures market lets you make take very high-risk, high-reward positions. Only do it if you know what you’re doing.
One simple strategy involves buying an index futures contract with a long-term expiration at the market price during a downturn.
For instance, let’s say you buy a one-year Dow Jones future contract after the market went down. Let’s say the index appreciates as you get closer to the end of the one-year mark. In this case, you could be looking at a tidy sum on settlement.
Why Trade Index Futures?
The three main benefits of trading stock futures indices are:
- Leverage – Opening a futures position means you get to enjoy a bigger total exposure than the capital you’ve put down when you opened your position. We refer to this capital as a margin requirement and typically ranges from 3 – 12% of the contract value. Essentially, you could make a large amount of money with a fraction of the capital.
- Liquidity – Futures markets tend to be very liquid, which makes them easier to trade. Except for global downturn events, price movements tend to remain fairly stable, especially as the futures contract nears maturity.
- Hedging – If your portfolio contains several stocks that are part of a single index, you could hedge market-specific risk. You might do it when you are concerned about systematic risk. This is the risk that the overall market may decrease in value. You could hold a short index futures position that can offset this risk. If the index does fall in value during a market downturn, your futures contract will profit. This profit will counteract the loss from your individual stock positions.
Drawbacks of Trading Stock Index Futures
The two notable drawbacks of trading stock futures indices are:
- Leverage Risks – Leverage is a double edge sword and doesn’t discriminate between profit and loss. Same way as you could make considerable gains with little capital, you could also lose your entire investment if the market doesn’t move in your favor.
- Cash and Margins – To participate in the futures markets, you need to put up an appropriate amount of margin as required by the exchange and your broker. If your trade experiences a significant loss, then a margin call may be triggered. In this case, you’ll need to top up your account to meet the minimum margin required, or your position will be liquidated.
The Bottom Line
Trading stock futures could be a great way to realize considerable profits for traders and speculators. It’s also a great tool to hedge your portfolio and minimize losses. Like any speculative market that deals with derivatives, stock index futures are not for everyone. But if you’re looking for a fast-moving trading opportunity and you know your way around the futures market, then this may be right for you. The key is to pay attention to technical analysis and any other factors that can influence the price of the underlying index. You should also consider fine-tuning your trading strategy so that you can limit your risk exposure.
