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In stock index futures contracts, there are two parties directly involved. One party the short position must deliver to a second party the long position an amount of cash equaling the contract's dollar multiplier multiplied by the difference between the spot price of a stock market index underlying the contract on the day of settlement IP spot and the contract price on the date that the contract was entered CP 0.
Thus, positive differences are paid by the seller and received by the buyer. Negative differences are paid by the buyer and received by the seller. When an investor opens a futures position, he or she does not pay the entire amount of the equity underlying the futures contract. The investor is required to put up only a small percentage of the value of the contract as a margin.
A margin is the amount of money required for investors to give to their brokers to maintain their futures contracts. Unlike margins paid for stock purchases, margins paid for stock index futures are not purchases or sales of actual securities. Instead, they represent agreements to pay or receive the difference in price between the index underlying the contract on the day of settlement IP spot and the contract price on the date that the contract was entered CP 0.
The exact amount of money needed to cover the margin is determined by two formulas. Both formulas are a function of the market price, the price of the index, and the strike price. The amount of money required for the margin is the greater result of the two formulas.
If the index moves against the sellers, they will be required to add to the margin amount. Known as a maintenance or variation margin, it is the minimum level to which investors' account equity can fall before they receive a margin call. When investors' equity in a stock index futures account falls below the maintenance level, they receive a margin call for enough money to bring the account up to the initial margin level.
This margin requirement mandates that holders of futures positions settle their realized and unrealized profits and losses in cash on a daily basis. These profits and losses are derived by comparing the trade price against the daily settlement price of the futures contract. The settlement price is broadcast by the exchanges soon after the markets close; it represents the pricing of the last 30 seconds of the day's trading.
Investors can use stock index futures to perform myriad tasks. Some common uses are: to speculate on changes in specific markets see above examples ; to change the weightings of portfolios; to separate market timing from market selection decisions; and to take part in index arbitrage, whereby the investors seek to gain profits whenever a futures contract is trading out of line with the fair price of the securities underlying it.
Investors commonly use stock index futures to change the weightings or risk exposures of their investment portfolios. A good example of this are investors who hold equities from two or more countries. Suppose these investors have portfolios invested in 60 percent U. They can do this by buying U. Stock index futures also allow investors to separate market timing from market selection decisions. For instance, investors may want to take advantage of perceived immediate increases in an equity market but are not certain which securities to buy; they can do this by purchasing stock index futures.
If the futures contracts are bought and the present value of the money used to buy them is invested in risk-free securities, investors will have a risk exposure equal to that of the market. Similarly, investors can adjust their portfolio holdings at a more leisurely pace. For example, assume the investors see that they have several undesirable stocks but do not know what holdings to buy to replace them.
They can sell the unwanted stocks and, at the same time, buy stock index futures to keep their exposure to the market. They can later sell the futures contracts when they have decided which specific stocks they want to purchase. Investors can also make money from stock index futures through index arbitrage, also referred to as program trading.
Basically, arbitrage is the purchase of a security or commodity in one market and the simultaneous sale of an equal product in another market to profit from pricing differences. Investors taking part in stock index arbitrage seek to gain profits whenever a futures contract is trading out of line with the fair price of the securities underlying it.
Thus, if a stock index futures contract is trading above its fair value, investors could buy a basket of about stocks composing the index in the correct proportion—such as a mutual fund comprised of stocks represented in the index—and then sell the expensively priced futures contract.
Once the contract expires, the equities could then be sold and a net profit would result. While the investors can keep their arbitrage position until the futures contract expires, they are not required to. If the futures contract seems to be returning to fair market value before the expiration date, it may be prudent for the investors to sell early.
Aside from the above uses of indexes, investors often use stock index futures to hedge the value of their portfolios. To implement a hedge, the instruments in the cash and futures markets should have similar price movements. Also, the amount of money invested in the cash and futures markets should be the same.
Toillustrate, while investors owning well-diversified investment portfolios are generally shielded from unsystematic risk risk specific to particular firms , they are fully exposed to systematic risk risk relating to overall market fluctuations. A cost-effective way for investors to reduce the exposure to systematic risk is to hedge with stock index futures, similar to the way that people hedge commodity holdings using commodity futures.
Investors often use short hedges when they are in a long position in a stock portfolio and believe that there will be a temporary downturn in the overall stock market. Hedging transfers the price risk of owning the stock from a person unwilling to accept systematic risks to someone willing to take the risk. To carry out a short hedge, the hedger sells a futures contract; thus, the short hedge is also called a "sell-hedge. The investors have been very successful with their stock picks.
Therefore, while their portfolios' returns move up and down with the market, they consistently outperform the market by 6 percent. Thus, the portfolio would have a beta of 1. Say that the investors believe that the market is going to have a 15 percent decline, which would be offset by the 1 percent received from dividends.
The net broad market return would be percent but, since they consistently outperform the market by 6 percent, their estimated return would be -8 percent. In this instance, the investors would like to cut their beta in half without necessarily cutting their alpha in half. They can achieve this by selling stock index futures. Thus, their portfolios would be affected by only half of the market fluctuation. 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. 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, at the end of September, the holder with a September futures contract one year earlier at 15, 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. 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 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. 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. Here's a hypothetical example to show how investors can speculate using 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. 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. 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.
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. CME Group. Hong Kong Exchanges and Clearing. Financial Industry Regulatory Authority.
Trading Skills. Financial Futures Trading. Stock Trading. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Table of Contents. What Are Index Futures? How Index Futures Work. Types of Index Futures. Index Futures and Margins.