If a securities is traded publicly, it has a derivative or other second-order byproduct. Put options, REITs, rainbows, and other derivatives are all dependent on an underlying stock, real estate, or perhaps several stocks, or anything else. So it is with futures, in which you wager on whether the price of a commodity will climb or decline by a given date. (However, no one in the market is bold enough to call it “betting.”) The preferred phrase for art is “risk transmission.” The commodity in issue may be perishable (for example, livestock or wheat) or not (silver, platinum).It may even be immaterial.
Take, for example, the Dow Jones Industrial Average or the S&P 500. A stock market index is essentially simply a number that indicates a group of stock prices that have been adjusted arithmetically. The index is an amount, but not one that you can taste or touch. However, we may go one step further and establish a futures contract for a stock index, which results in speculators betting on which direction the market will go in. To put it another way, purchasing and/or selling a number. A number with significant cultural and apparent importance, but ultimately only a number.
Here’s an illustration. The Dow has futures contracts that payoff at the conclusion of the quarter. The Dow closed at 16,141.74 on October 15, 2014. (Despite the fact that some of its components are trading over $100, the index is still quoted to two decimal places for some reason.) As a result, the next four futures closing dates are December 2014, March 2015, June 2015, and September 2015.
As of this writing, we’re in a chronologically confined bear market, with the Dow at its lowest level since April and 7% below its all-time high from a month ago. The Dow index futures reflect the broader gloom, with the price for a December 2014 contract presently trading at 16,049. The doomsday scenario continues into 2015, with the remaining consecutive futures trading at 15,936, 15,850, and 15,760, respectively.
15,760 is certainly a significant loss. Will the market really lose 2.4% of its value between now and the end of next summer? Yes, according to conventional thinking. Or, to put it another way, collective wisdom has established that 15,760 is the point at which speculators have agreed to meet. It’s similar to a football point spread. Assume the Buccaneers are favored by three points over the Jets next week. This figure does not have to be an exact depiction of the teams’ relative strengths. Instead, when the Buccaneers are favored by three points, it signifies that just as much money has been committed to the argument that “they will” as to the premise that “they will not.” Price will be distorted by excessive pessimism or optimism.
More fundamentally, why are the impending futures prices heading downward instead of upward? Or perhaps remaining neutral? Economic instability, slow development, and a low degree of political unrest are the traditional culprits. Add in additional negatives, no matter how unrelated to the stock market (e.g., ISIS, Ebola), and we’ve arrived.
Stock index futures should, on the surface, follow real index fluctuations. If you buy an index fund that follows the Dow or the S&P 500, you may expect to pay a price that is precisely equal to the index’s level. The two are in sync, or almost so. However, one significant distinction between stock index futures and such index funds is that the former do not account for dividends. By owning holdings in the many equities that compose the index, an index fund is eligible for whatever dividends the management of those firms decide to pay out to shareholders. A stock index future is an abstract instrument that does not have a stake in the stocks that compose the index and so has no dividend potential.
The Bottom Line
Stock index futures are not the same as futures contracts for more tangible commodities like cotton, soybeans, or Texas light sweet oil. When the index futures contracts mature at the end of the quarter, the contract holders deliver…nothing. Only the finances to complete the deal. If the Dow finishes the year at 16,000, the holder who purchased a September 2015 futures contract for 15,760 makes a little profit. Stock index futures are often bought by portfolio managers looking to hedge against probable losses. Stock index futures, however, constitute an efficient manner of transferring risk in a market that may be homicidally unpredictable at times, whether owned by a careful fund manager or a reckless trader searching for an obscure new product to sink his teeth into.
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