How to Use Index Futures

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How to Use Index Futures

A stock index futures contract commits two parties to an agreed-upon price for the underlying index at a future date. The Marchfutures on the S&P 500 Index, for example, indicate the anticipated value of the index at the conclusion of business on the third Friday in March. It’s a zero-sum game, as with every derivative, since one side is long the futures contract and the other is short, and the loser must pay the winner the difference between the agreed-upon index futures price and the closing value of the index at expiry. Many futures contracts, however, are closed far before their expiry date.

Key Takeaways

  • Stock index futures, such as the S&P 500 E-mini Futures (ES), indicate predictions about a stock index’s price in the future, based on dividends and interest rates.
  • Index futures are two-party agreements that are regarded a zero-sum game because when one party wins, the other party loses, and there is no net transfer of wealth.
  • While the U.S. stock market is most busy from 9:30 a.m. to 4:00 p.m. ET, stock index futures trade almost continuously.
  • Outside of regular market hours, the increase or fall in index futures is often used to forecast whether the stock market will open higher or lower the following day.
  • When index futures prices stray too far from fair value, arbitrageurs use stock market buy and sell algorithms to benefit on the discrepancy.

Fair Value of an Index Future

Index futures are highly associated with the underlying index, although they are not identical. Unlike an investor who buys the component companies or an exchange-traded fund that follows the index, an investor in index futures does not receive (if long) or owe (if short) dividends on the stocks in the index.

Only at expiry must the index futures price match the underlying index value. At all other times, the futures contract has a fair value compared to the basis index. The basis takes into account the predicted dividends foregone as well as the differential in financing costs between the index futures and its equity components. Because the dividend adjustment overcomes the financing cost when interest rates are low, the fair value of index futures is often lower than the index value.

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Index Futures Arbitrage

The fact that index futures have a fair value does not imply that they trade at that price. Index futures are used by market players for a variety of objectives, including hedging, altering asset allocation via index futures overlay schemes or transition management, and blatant speculating on market direction. Because index futures are more liquid than the market for the index’s constituent components, investors who need to change their equity exposure quickly buy index futures—even if the price isn’t equal to fair value.

When the price of an index futures contract goes away from its fair value, it presents a trading opportunity known as index arbitrage. The biggest banks and securities companies have computer models that watch the ex-dividend calendar for the index components and factor in the businesses’ borrowing rates to determine the index’s fair value in real-time.

When the price premium or discount to fair value of index futures covers their transaction costs (clearing, settlement, commissions, and expected market impact) plus a small profit margin, the computers enter the market, either selling index futures and buying the underlying stocks if futures trade at a premium, or vice versa if futures trade at a discount.

Index Futures Trading Hours

Index arbitrage maintains index futures prices near to fair value, but only when both index futures and underlying equities are trading concurrently. While the stock market in the United States begins at 9:30 a.m. EST and closes at 4:00 p.m. EST, index futures trade around the clock on systems such as Globex, a CME Group electronic trading system. Index futures liquidity falls outside of stock exchange trading hours because index arbitrage players can no longer ply their trade. If the futures price becomes erratic, they cannot hedge an index futures purchase or sale by selling or buying underlying equities. Other market players, though, are still active.

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Index futures are traded on margin, which is a deposit made with the broker before opening a futures contract. For example, an investor purchasing $100,000 in futures must put up a portion of the principal amount rather than the total $100,000.

Index Futures Predict the Opening Direction

Assume excellent news arrives from outside overnight, such as a central bank lowering interest rates or a nation reporting stronger-than-expected GDP growth. Local equities markets are likely to climb, and investors may predict a higher US market as well. The price of index futures will rise if they purchase them. And, with index arbitrageurs staying away until the U.S. stock market opens, nobody will be able to counterbalance the purchasing pressure, even if the futures price surpasses fair value. However, as soon as the New York Stock Exchange opens, the index arbitrageurs will execute whatever transactions are required to put the index futures price back in line—in this case, by purchasing component stocks and selling index futures.

However, investors cannot just look at whether the futures price is higher or lower than the previous day’s closing value. The dividend adjustments to the fair value of index futures fluctuate overnight (they remain constant during the day), and the stated market direction is determined by the price of index futures relative to fair value, independent of the previous close. Ex-dividend dates are also not uniformly distributed throughout the calendar; they tend to concentrate around certain dates. Index futures may trade above the preceding close on a day when many major index components go ex-dividend, implying a lower opening.

In the Short Term

Index futures prices are often a great indication of opening market direction, but the signal is only valid for a limited time. Trading on Wall Street is generally tumultuous at the opening bell, accounting for a disproportionate chunk of overall trading activity. If an institutional investor participates in a major purchase or sell program across numerous equities, the market effect may outweigh any price change indicated by index futures. Of course, institutional traders monitor futures prices, but the larger the orders they must execute, the less crucial the index futures’ direction signal becomes.

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Index arbitrage activities might also be hampered by late openings. Although the majority of trading on the NYSE begins at 9:30 a.m. ET, not all stocks begin trading at the same time. The starting price of certain stocks is determined by an auction system, and if the bids and offers do not overlap, the stock stays closed until matching orders arrive. Index arbitrage players will not intervene until they can execute both sides of their bets, which implies that the index’s largest—and ideally all—stocks must have opened. The longer index arbitrageurs remain on the sidelines, the more likely other market action will cancel out the index futures direction signal.

The Bottom Line

If the S&P 500 Index futures go higher outside of market hours, implying that the stock market will climb at the open, investors who plan to sell that day may prefer to wait until after the market opens before placing their order (or set a higher price limit).Buyers may wish to wait if index futures indicate a lower opening. However, nothing is assured. Most of the time, index futures forecast the opening market direction, but even the greatest forecasters may be inaccurate.

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