Index Futures in The Stock Market
A contract for stock index futures is based on the level of a particular stock index such as the S&P 500 or the Dow Jones Industrial Average. The agreement calls for the contract to be bought or sold at a designated time in the future. Just as hedgers and speculators buy and sell futures contracts and options based on a future price of corn, foreign currency, or lumber, they may—for mostly the same reasons—buy and sell contracts based on the level of a number of stock indexes.
Stock index futures may be used to either speculate on the equity market’s general performance or to hedge a stock portfolio against a decline in value. It is not unheard of for the expiration dates of these contracts to be as much as two or more years in the future, but like commodity futures contracts most expire within one year. Unlike commodity futures, however, stock index futures are not based on tangible goods, thus all settlements are in cash. Because settlements are in cash, investors usually have to meet liquidity or income requirements to show that they have money to cover their potential losses.
All stock index futures contracts have a value equal to their price multiplied by a specified dollar amount. To illustrate, the price of a stock index futures contract based on the New York Stock Exchange (NYSE) Composite Index is derived by multiplying the index level value by $500. This value results because each futures contract is equal to $500 times the quoted futures price. So, if the index level is determined to be 200, the corresponding stock index future would cost $100,000. The index level is marked-to-market, meaning that at the end of each day its value is adjusted to reflect changes in the day’s share prices.
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 ).
If an investor sells a six-month NYSE Composite futures contract (with a multiplier of $500 per index point) at 444 and, six, months later, the NYSE Composite Index closes at 445, the short party will receive $500 in cash from the long party.
Similarly, if an investor shorts a one-year futures contract at 442 and the index is 447 on the settlement day one year later (assuming that the multiplier is at $500), the short seller has to pay the long holder $2,500.
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.
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.S. equities and 40 percent Japanese equities and want to increase their systematic risk to the U.S. market and reduce these risks to the Japanese market. They can do this by buying U.S. stock index futures contracts in the indexes underlying their holdings and selling Japanese contracts (in the Nikkei Index).
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 100 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.