What Are Index Futures? Definition, Types, and How to Profit

What Are Index Futures?

The term index futures refers to futures contracts that allow traders to buy or sell a contract that is derived from a financial index today to be settled at a future date. Originally intended for institutional investors, index futures are now open to individual investors as well. Traders use these contracts to speculate on the price direction indexes, such as the S&P 500 and the Dow Jones Industrial Average (DJIA). They also use index futures to hedge their equity positions against losses.

KEY TAKEAWAYS

• Index futures are contracts to buy or sell a financial index at a set price today, to be settled at a date in the future.

• These contracts were originally meant solely for institutional investors but are now open to anyone.

• Portfolio managers use index futures to hedge their equity positions against a loss in stocks.

• Speculators can also use index futures to bet on the market's direction.

• Some of the most popular index futures are based on equities, including the E-mini S&P 500, E-mini Nasdaq-100 and E-mini Dow. International markets also have index futures.

Understanding Index Futures

An index tracks the price of an asset or a group of assets, such as equities, commodities, and currencies. A futures contract is a type of derivative that obligates traders to buy or sell the underlying asset on a set day at a predetermined price. An index future, therefore, is a legal contract that obligates traders to buy or sell a contract that is derived from a stock market index by a certain date at a predetermined price.

Index futures, which are also called stock or equity market index futures, function just like any other futures contract. They give investors the power and obligation to deliver the cash value of the contract based on an underlying index at a specified future date at an agreed-upon price. Unless the contract is unwound before expiration through an offsetting trade, the trader is obligated to deliver the cash value on expiry.

Traders use index futures to hedge or speculate against future price changes in the underlying equity index. For example, the S&P 500 Index tracks the stock prices of 500 of the largest companies traded in the U.S. An investor could buy or sell index futures on the S&P 500 to hedge or speculate on gains or losses of the index.

Index futures do not predict future index performance.

Types of Index Futures

Some of the most popular index futures are based on equities, which means investors hedge their bets on the individual index named in the contract.

For instance, traders can invest in the S&P 500 index by purchasing E-mini S&P 500 futures contracts. Investors can also trade futures for the Dow Jones and Nasdaq 100 Index. There are the E-mini Dow and E-mini Nasdaq-100 futures contracts, or their smaller variants the Micro E-mini Dow and Micro E-mini Nasdaq-100.

Outside of the U.S., there are futures available for the DAX Stock Index of 30 major German companies and the Swiss Market Index, both of which trade on the Eurex. In Hong Kong, Hang Seng Index (HSI) futures allow traders to speculate on that market's major index.

Products may use different multiples to determine the contract price. For example, the E-mini S&P 500 futures contract, which trades on the Chicago Mercantile Exchange (CME), has a value of $50 times the value of the index. So if the index trades at 3,400 points, the market value of the contract would be 3,400 x $50 or $170,000.

The CME delisted the standard-sized S&P 500 index futures and options contracts in September 2021.2 These contracts were priced at $250 times the level of the S&P 500. That means if the index traded at 3,400 points, then the market value of the contract would be 3,400 x $250 or $850,000.

Index Futures and Margins

Futures contracts don't require the buyer to put up the entire value of the contract when entering a trade. Instead, they only require the buyer to maintain a fraction of the contract amount in their account. This is called the initial margin.

Index futures prices can fluctuate significantly until the contract expires. Therefore, traders must have enough money in their accounts to cover a potential loss, which is called the maintenance margin. The maintenance margin sets the minimum amount of funds an account must hold to satisfy any future claims.

The Financial Industry Regulatory Authority (FINRA) requires a minimum of 25% of the total trade value as the minimum account balance, although some brokerages will demand greater than 25%.3 And as the value of the trade climbs before expiration, the broker can demand additional funds be deposited into the account. This is called a margin call.

It's important to note that index futures contracts are legally binding agreements between the buyer and seller. Futures differ from an option because a futures contract is considered an obligation. An option, on the other hand, is considered a right the holder may or may not exercise.

Profits and Losses from Index Futures

An index futures contract states the holder agrees to purchase an index at a particular price on a specified future date. Index futures typically settle quarterly in March, June, September, and December. There are usually several annual contracts as well.

Equity index futures are cash-settled. This means that there's no delivery of the underlying asset at the end of the contract. If the price of the index is higher than the agreed-upon contract price at the expiry date, the buyer makes a profit while the seller (who is known as the future writer) suffers a loss. In the opposite scenario, the buyer suffers a loss while the seller makes a profit.

For example, if the Dow closes at 16,000 at the end of September, the holder with a September futures contract one year earlier at 15,760 ends up reaping a profit.

Profits are determined by the difference between the entry and exit prices of the contract. As with any speculative trade, there are risks the market could move against the position. As mentioned earlier, the trading account must meet margin requirements and could receive a margin call to cover any risk of further losses. The trader must understand that many factors can drive market index prices, including macroeconomic conditions such as economic growth and corporate earnings.

Index Futures for Hedging

Portfolio managers often buy equity index futures as a hedge against potential losses. If the manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures.

Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline. In the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value, offsetting the losses from the stocks.

The fund manager could hedge all of the downside risks of the portfolio, or only partially offset it. The downside of hedging is that this reduces profits if the hedge isn't required. So if the investor from the previous section with a September futures contract shorts index futures and the market rises, the index futures decline in value. The losses from the hedge would offset gains in the portfolio as the stock market rises.

Speculation on Index Futures

Speculation is an advanced trading strategy that is not suited for many investors. However, experienced traders tend to use index futures to speculate on the direction of an index. Instead of buying individual stocks or assets, a trader can bet on the direction of a group of assets by purchasing or selling index futures.

For example, to replicate the S&P 500 Index, investors would need to buy all 500 stocks in the index. Instead, index futures can be used to bet on the direction of all 500 stocks, with one contract creating the same effect of owning all 500 stocks in the S&P 500.

Pros

• Index futures can hedge against declines in similar holdings

• Brokerage accounts require only a fraction of the contract's value held as a margin

• Index futures allow for speculation on the index price movement

• Helps businesses lock in commodity prices for commodity futures

Cons

• Unnecessary or wrong direction hedges will damage any portfolio gains

• Brokers can demand additional funds to maintain the account's margin amount

• Index futures speculation is a high-risk undertaking

• Unforeseen factors may cause the index to move opposite from the desired direction

Index Futures vs. Commodities Futures Contracts

By their nature, stock index futures operate differently than futures contracts. These contracts allow traders to buy or sell a specified amount of a commodity at an agreed-upon price on an agreed-upon date in the future. Contracts are normally exchanged for tangible goods such as cotton, soybeans, sugar, crude oil, gold, and what.

Investors generally trade commodity futures as a way to hedge or speculate on the price of the underlying commodity. Unlike index futures, which are cash-settled, long position holders of commodities futures contracts will need to take physical delivery if the position has not been closed out ahead of expiry.

Businesses frequently use commodity futures to lock in prices for the raw materials they need for production.

Examples of Index Futures

Here's a hypothetical example to show how investors can speculate using index futures. Let's say an investor decides to speculate on the S&P 500. They buy the futures contract when the index trades at 2,000 points, resulting in a contract value of $100,000 ($50 x 2,000). The E-mini S&P 500 futures are priced at $50 multiplied by the index value.

Because index futures contracts don't require the investor to put up the full 100%, they need only to maintain a small percentage in a brokerage account.

• Scenario 1: The S&P 500 Index falls to 1,900 points. The futures contract is now worth $95,000 ($50 x 1,900). The investor loses $5,000.

• Scenario 2: The S&P 500 Index rises to 2,100 points. The futures contract is now worth $105,000 ($50 x 2,100). The investor earns a $5,000 profit.

How Do You Trade Index Futures?

Index futures are derivatives that give you the right and the obligation to buy or sell stock market indexes at a specified date in the future at an agreed-upon price. You may trade futures for indexes like the S&P 500, Dow Jones, Nasdaq 100 as well as foreign market indexes, such as the FTSE 100 or the Hang Seng. In order to trade index futures, you'll need to open an account with a brokerage firm. Once your account is open, choose the index you want to trade and decide whether you want to go long (you believe the price will increase) or short (you believe the price will decrease). Be sure you keep an eye on your contract as it nears the expiration date.

Can Index Futures be Used to Predict Market Performance?

Index futures are generally considered a bet—not a predictor. Traders who invest in equity index futures bet or speculate on the index moving in a particular direction. Investors who take long positions speculate that the index's price will increase while those who take short positions bet that the price will drop. Various factors can move markets, which means they can go in any direction. As such, there is no fail-safe predictor for the market, including index futures.

Is Index Futures Trading Riskier Than Stock Trading?

Index futures are neither riskier or less riskier than stocks. That's because their prices depend on the prices of the underlying index. The risk comes from speculative positions taken by investors who use leverage to make their trades. But they are also used as a hedging tool, which can reduce an investor's overall risk.

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