Index Futures - Meaning, Examples, Types, How it Works? (2024)

What Are Index Futures?

Index futures are legally binding futures contracts that allow traders to trade derivatives at a predetermined price on a future date. The instruments exchanged under these contracts may include stocks, commodities, or currencies and must be settled in cash on expiry.

Among various reasons to use these futures contracts is speculating on the future price direction of an underlying asset or index to make profits. Similarly, it enables investors to hedge their stock portfolio or equity positions against potential losses. Besides, these can be used for volatility trading, spread trading, and determining market sentiment. A futures broker can help with these activities on any stock exchange.

• Index futures are legal futures contracts in which traders actively trade derivatives of an underlying asset or index at a predetermined price, with the transaction to be settled at a future date.
• The values of futures contracts are determined by multiplying a fixed proportion with the price movements of the stocks held by the relative indices.
• Experienced traders use futures contracts for speculation to make profits and for hedging to offset possible losses.
• The most common examples include E-mini S&P 500, E-mini Dow Jones, and E-mini NASDAQ 100.

How Does Index Futures Investing Work?

Index futures are like any other futures contracts and more active than traditional stock market securities. The main difference is that these are derivatives. It allows investors to benefit from price changes in an underlying asset or index.

Stock market indices comprise securities values of which keep fluctuating throughout the trading day. The constant liquidity and volatility in the market let investors and traders benefit from stock price changes. And investing in different types of futures contracts is a proven way to do so.

A futures broker can help with buying or selling positions of the equity futures contracts. These contracts have an expiration date, and the trader must buy or sell booked holdings by that date or before. Once the contract has expired, the trader can settle in cash based on the underlying asset's or index's value. Here are the steps involved in the process:

1. A future buyer (investor) and a future seller (trader) enter a futures contract.
2. The investor speculates on the future price movements of the stocks bought.
3. It then places a buy order, assuming the price might go up after a specific period.
4. On the other hand, the trader places a sell order, predicting the prices to go down after that period.
5. The interested seller and buyer book their positions under the futures contract, which they are obligated to honor at any cost.
6. The investor and the trader then pay and collect the difference in the agreed-upon contract price at a future date.

Types Of Index Futures

All major stock indexes provideglobal index futuresfor trading, with equities being the most popular option among investors. However, indices set their prices using different multiples.

• E-mini S&P 500
• Micro E-mini S&P 500
• E-mini Dow Jones
• Micro E-mini Dow Jones
• E-mini NASDAQ 100
• Micro E-mini NASDAQ 100
• Nikkei 225 Futures
• Swiss Market Index
• Financial Times Stock Exchange Index
• DAX Stock Index

Index Futures Examples

To understand the basic and advanced concepts even better, let us consider two examples below:

Example #1

Sarah wants to invest in S&P 500, but she is running short of the sufficient funds required. So, she decides to speculate on the futures contracts. Sarah buys a lot of derivatives priced at $1,000 per share. The lot consists of 50 shares. Hence, she invests a total of $50,000 in S&P 500 index futures contracts.

On the predetermined date of sale, the derivative price rose to $1,200 per share, amounting to the total selling price of $60,000. Therefore, selling the lot to the interested buyer, who has already booked the buy position for the future date, lets Sarah earn a profit of $10,000.

Example #2

The E-mini NASDAQ 100 futures contracts set to expire in June 2021 are expected to trade at13356.75on May 11, 2021. However, the presence of sellers in the market would push the contracts below the value. It will further cause the retracement level to range between 13165.25 and 13132.00.

Likewise, the increased number of buyers would cause the value to move above the threshold, creating a bullish scenario. In that case, the retracement level would range between 13617.00 and 13722.50.

The future buyers and future sellers trading for these positions are likely to speculate on market movements. Based on their analysis, they can estimate who would profit or suffer a loss on a future date.

How To Trade And Settle Index Futures?

The buyer and seller lock buy and sell bids in index futures investing or trading. Both parties agree to legally close their positions at a particular price and on a future date. A futures broker places the buy and the sell orders on behalf of traders. It is then time to set a long and short position with initial and maintenance margins for buy and sell orders.

As far as the settlement of futures contracts is concerned, it is purely cash-based. Also, the seller and the buyer can pay and collect the difference in the agreed-upon contract price in cash on the expiration date. In simpler words, the higher price results in profit for the buyer, while the lower price makes the seller suffer a loss.

Uses of Index Futures

Lack of sufficient funds to make hefty investments in stocks makes futures contracts one of the most viable trading options. It is a derivative-based investment wherein traders can spend less with an opportunity to profit more. Besides, there are two ways to use the equity or stock index futures:

#1 - Speculation

These futures contracts allow experienced traders to speculate on the direction of an underlying asset or index in the future. It simply means the investors do not need to buy or sell futures contracts and instead bet on a group of assets by speculating a bullish or bearish market. Speculation requires traders to stay updated with the market trends to lock profitable positions.

#2 - Hedging

Many traders use these futures contracts for hedging to offset losses that they might incur because of extreme stock price fluctuations. When the stock prices decline, investors with a portfolio of stocks or equity index options start selling futures contracts to minimize the potential losses. As opposed to a fall in stock prices, futures contracts rise in value in this situation.

Frequently Asked Questions (FAQs)

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