Stock Market Index Futures
From FXPedia
A stock market index futures is a form of futures contract whereby two parties agree to complete a transaction at a future date. In the case of a stock market index futures contract, the value of the specified stock market index serves as the underlying commodity for the agreement. Once the contract expires, the holder of the contract will either pay or receive the difference between the opening price for the index and the actual index price at maturity.
Index futures are traded with a multiplier that adds leverage to the trade and inflates the overall value. This multiplier provides greater opportunity to profit, but also increases the overall risk for the participants. Currently, the multiplier for the Dow Jones is 10, while the multiplier for the NASDAQ and the S&P 500 is set at 100 and 250 respectively.
To understand how stock market index futures work, we’ll look at an example using the Dow Jones. To make it easier, we’ll assume that a single contract of a Dow Jones Index future is selling for $10,000 – when taking the multiplier of 10 into account, this means that for an initial investment of $10,000, you are actually holding a contract worth $100,000. As the holder of this contract, every single point change in the Dow translates into a $10 change for you – in other words, if the Dow falls 10 points, you will be down $100 (10 points x multiplier of 10 = 100). On the other hand, if the Dow were to climb 50 points, you would be ahead $500 (50 points x multiplier of 10 = 500).
Like all futures contracts, a stock market index future is marked-to-market, meaning that accounts are updated at the close of business each day to reflect the latest market prices. The accounts of the buyer (long position) as well as the seller (short position) are marked-to-market each business day until the contract expires.
During the time that the contract is in force, balances change frequently but an actual transfer of funds happens on the expiry date. For instance, if you are holding a single long index futures contract based on the Dow Jones, and at expiry the Dow is valued at 1,257 points higher than the original contract, you would receive $12,570 (1,257 x multiplier of 10 – 12,570) from the seller. However, if at expiry the Dow is down 750 points, you must pay the seller $7,500.
Market Index Futures as a Predictive Tool
In North America, the Dow Jones futures index and the S&P futures index are used as indicators to gauge the response of how overnight events and the Asian and European markets could influence the trading day in North America. When Dow futures rise, it signals that investors believe that the Dow Jones index will increase as well suggesting that trading will be positive for the short term at least. Because Dow futures begin trading on the Chicago Board of Trade more than an hour before the New York Stock Exchange opens, Dow futures can provide early insight into the thoughts of traders. The same holds true for S&P 500 and NASDAQ 100 futures which both begin trading on the Chicago Mercantile Exchange one hour before the NYSE opens.
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