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Index Futures

: Summary


Index Futures - Definition


Index Futures are futures contracts with indexes as their underlying asset.

Index Futures - Content

  • What Are Index Futures?

  • Why Trade Index Futures?

  • How Does Index Futures Affect Stocks?

  • How To Trade Stock Index Futures?

  • Benefits of Trading Index Futures

  • Risks of Trading Index Futures

  • History of Trading Index Futures


  • What Are Index Futures?


    Index futures are futures contracts with an index instead of a physical asset as its underlying asset. Indeed, index futures are one of the most important financial futures in the world today and opened up the way for futures traders to trade and profit from the performance of a specific index directly instead of having to trade the entire basket of asset covered by the index.

    The most important of index futures are index futures based on broad market indexes such as the S&P500 Futures and the Nikkei225 futures. These stock index futures allow futures traders to "Buy the market" or "sell the market" for the first time without having to simultaneously trade the hundreds of stocks that these indexes cover. In a way, trading index futures is really trading all the stocks or assets covered by an index in the capital weightage represented in the index. In fact, there are also mini index futures or simply known as "minis" which allows retail traders to perform leveraged speculation on their underlying index using very little money.

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    Why Trade Index Futures?


    There are three main reasons why index futures are being traded; Leveraged Speculation, Hedging and Arbitrage. Of course the underlying reason behind all three reasons is to result in having more cash value in a trading account than if index futures are not traded.

    Leveraged Speculation
    Leveraged speculation is attempting to profit from a directional move in the underlying asset using leverage. In fact, leveraged speculation is the main reason why index futures are being traded around the world. Simply put, leveraged speculation using index futures involves taking the long side of an index futures contract if you think the underlying index is going to go up and taking the short side if you think the underlying index is going to go down. Due to the leveraged nature of index futures and the relatively tight bid ask spread and low commissions, it is also extremely suitable for day trading where day traders speculate on extremely short intraday moves for a daily profit. Small moves of 0.1% on the underlying index can easily transform into profits of 1% or more depending on the leverage offered by the particular index futures. Daily profits of 1% can easily add up to hundreds of percents annually if done consistently.

    On top of speculating on the directional move of the underlying index, index futures also allows you to speculate on the volatility of the underlying index through the difference in futures price of contracts of different months. Typically, the higher the volatility in the market, the greater the price difference would be and the lower the volatility, the lower the price difference. Such changes in the futures contract spread can be speculated using futures calendar spreads.

    Index Futures Trading Example:

    The S&P500 is at 1125.75 today. Assuming you are bearish on the S&P500, you could take the short side of its near term futures contract which is currently the June 2010 contract priced at 1125.8 points. Initial margin requirement for this contract is about $28,000. Assuming you are short one contract of the June 2010 and S&P500 drops to 1000 points, you make:

    1125.75 - 1000 = 125.75 points
    125.75 x $250 = $31,437.50
    $31,437.50 / $28,000 = 112% profit

    The S&P500 dropped by only 11% but you make 112% profit by speculating through the S&P500 index futures. That's speculating with leverage.


    Hedging
    Futures contracts are designed as hedging tools and continue to be important as a hedging tool today no matter what the underlying asset is. Hedging using index futures is good for institutional investors like mutual funds and hedge funds who might be holding a basket of stocks mimicking the behavior of a particular index. For instance, an S&P500 mutual fund holding all or most of the stocks represented in the index could hedge their entire portfolio using the S&P500 stock index futures instead of periodically selling or readjusting their stock holdings which results in more expenses and hassle.

    The only problem with hedging a portfolio using index futures is that there will always be a tracking error between your portfolio and the S&P500 itself, no matter how slight, compound that with the fact that there is also a difference in futures price and the actual index cash price, hedging with futures becomes a lot trickier and less accurate than hedging with options.

    Arbitrage
    Due to the relatively low commission involved in futures trading and that arbitrage opportunities are somewhat easier to spot, futures index arbitrage has been the favorite spot of institutional investors worldwide. Quick profits of 0.5% to 1% every time an index arbitrage opportunity is taken advantage of can happen many times a day and can add up to extremely significant profits every year. This is why billions continue to be pumped into quicker and quicker software and hardware in order to spot and take advantage of arbitrage opportunities. In fact, the need for speed in futures index arbitrage is so critical that whole servers are now directly hosted in electronic exchanges and connected using gold cable.

    OppiE's Note Due to the need for speed and low commissions, futures arbitrage isn't really a profitable venture for most retail traders who lacks the technology to spot these opportunities ahead of the institutions and the low commissions to ensure arbitrage remains profitable.





    How Does Index Futures Affect The Stock Market?


    Stock index futures, especially the S&P500 stock index futures has been at the heart of a world wide controversy about the whether or not index futures could be manipulated and whether or not it could adversely affect stock prices. In fact, S&P500 stock index futures have been partially and mistakenly blamed for the Black Monday market crash in 1987. By virtue of the fact that index futures are cash delivered instead of physically delivered like commodities futures, it does not have the ability to pull the spot price towards the futures price but it could instead pull the futures price to the spot price.

    In fact, theoretically, stock index futures could slow down stock market crashes due to the fact that large funds and institutions could hedge their entire portfolio by going short on stock index futures rather than having to sell their stocks which will inevitably quicken crashes. However, this effect is too minimal as retail investors still make up the majority of the market and the market will ditch as much as it have to as soon as retail investors and traders start selling off their stock holdings.

    So, what does stock index futures really do to the stock market?

    Well, after much intensive studies all over the world, it appears that stock index futures do not cause the stock market to crash harder. In fact, the Dow has crashed by a smaller amount after stock index futures start and by a smaller amount during the recent 2008 crash than markets without stock index futures like the Chinese stock market. In fact, there are no conclusively significant impact on the stock market at all primarily due to the fact that no physical assets are actually exchanged at the end of the life of a stock index futures.

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    How To Trade Stock Index Futures?


    Speculating using stock index futures is exactly the same as speculating in any futures contract; Taking the Long side when bullish and taking the short side when bearish.



    Benefits Of Trading Index Futures


    The main benefit of trading Index Futures is the ability to speculate on the move of the entire basket of stocks (or assets) without having to buy up all of the assets that constitute the index. In fact, buying up all of the assets that make up an index isn't only expensive but hard to achieve simultaneously without the use of special softwares. Commission on trading index futures is also typically lower than buying or shorting all of the assets that make up the index and there is no need to deliver or take delivery on all of the assets of the index upon expiration since index futures are cash delivered futures.




    Risks of Index Futures


    The single most significant risk of trading Index Futures is that fact that you can lose more than the money you initially started the trade with. If you are long a Index Futures position and the stock drops drastically in a single day, you could lose enough in one day to warrant a margin call and if you don't have enough money to fulfill the margin call, your position would not only be forcefully closed but you would also end up owing money to your broker. This is how many multi-billion dollar companies collasped overnight trading futures. As such, careful risk management in terms of leverage and cash reserve needs to be planned out when trading Index Futures.

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    Brief History Of Index Futures


    The first index futures started in February of 1982, known as the Value Line contract started by the Kansas City Board of Trade, followed by the S&P500 index futures in April of the same year. Since then, a new stock index futures is started in a new market almost every year up to 1999. In 2010, one of the world's most important market, the Chinese market, also started stock index futures trading on its hushen300 index.



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