How to use index futures

Stock index futures contracts bind the two parties to the agreed value of the underlying index on a specific future date. For example, the March futures of the S&P 500 index reflect the expected value of the index at the close of trading on the third Friday of March. Like any derivative, this is a zero-sum game, because one party is long in the futures contract and the other is short. The loser must pay the winner the difference between the agreed index futures price and the closing price of the index at expiration. However, many futures contracts are closed long before they expire.

Key points

  • Stock index futures, such as the S&P 500 E-mini futures (ES), reflect expectations for the future price of the stock index taking into account dividends and interest rates.
  • Index futures are an agreement between two parties and are considered a zero-sum game. Because one party wins and the other party loses, there is no net transfer of wealth.
  • Although trading in the US stock market is most active from 9:30 a.m. to 4:00 p.m. Eastern time, stock index futures are almost always traded 24/7.
  • The rise or fall of stock index futures outside of normal trading hours is usually used as an indicator of whether the stock market opens higher or lower the next day.
  • When the index futures price deviates too far from the fair value, arbitrageurs will deploy buying and selling procedures in the stock market to profit from the difference.

Fair value of index futures

Although index futures are closely related to the underlying index, they are not exactly the same. Unlike investors who buy constituent stocks or index-tracking exchange-traded funds, index futures investors will not receive (if long) or owe (if short) dividends on index stocks.

The price of an index futures must be equal to the value of the underlying index only at expiry. At any other time, the fair value of the futures contract relative to the index is called the basis. This basis reflects the difference in expected forfeited dividends and financing costs between the index futures and its stock components. When interest rates are low, dividend adjustments exceed financing costs, so the fair value of index futures is usually lower than the index value.

Index futures arbitrage

Just because index futures have a fair value does not mean that they are traded at that price. Market participants use index futures for many different purposes, including hedging, adjusting asset allocation through index futures stacking plans or transition management, or direct speculation in the direction of the market. Index futures are more liquid than the market in the various components of the index, so investors are eager to change their stock exposure to trade index futures even if the price is not equal to the fair value.

Whenever the index futures price deviates from the fair value, it creates a trading opportunity called index arbitrage. Computer models maintained by major banks and securities companies can track the ex-dividend calendar of index components, and consider the company’s borrowing costs to calculate the fair value of the index in real time.

Once the price premium or discount of index futures exceeds its transaction costs (clearing, settlement, commission and expected market influence) plus a small profit margin, the computer will jump in and either sell or buy index futures. If futures are traded at a premium, then the underlying stock, if futures are traded at a discount, the opposite is true.

Index futures trading hours

Index arbitrage brings the price of index futures close to fair value, but only if the index futures and the underlying stock are traded at the same time. Although the US stock market opens at 9:30 am and closes at 4 pm, index futures are traded 24/7 on platforms such as Globex (an electronic trading system operated by CME Group). The liquidity of index futures declines outside the trading hours of the stock exchange because index arbitrage participants can no longer trade. If futures prices become irregular, they cannot hedge index futures trading by hedging the underlying stocks. But other market participants are still active.

Index futures are traded on margin, which is the margin held by the broker before the futures position is opened. For example, an investor who purchases futures worth US$100,000 must pay a certain percentage of the principal, not the entire US$100,000.

Index futures forecast opening direction

Suppose that good news comes out overnight, such as the central bank lowering interest rates or a country’s reported GDP growth is stronger than expected. The local stock market may rise, and investors may also expect the US market to strengthen. If they buy index futures, the price will rise. And because index arbitrageurs stay on the sidelines before the US stock market opens, no one will offset the buying pressure even if the futures price exceeds the fair value. However, once the New York Stock Exchange is open, the index arbitrageur will execute any trades needed to bring the index futures prices back to consistency—in this case, by buying the constituent stocks and selling the index futures.

However, investors cannot just check whether the futures price is higher or lower than the previous day’s closing price. Dividend adjustments to the fair value of index futures vary overnight (they are constant every day), and the indicated market direction depends on the price of the index futures relative to the fair value, regardless of the previous closing price. Ex-dividend days are not evenly distributed on the calendar; they tend to cluster on certain dates. On the day when several major index stocks go ex-dividend, index futures may be higher than the previous closing price, but it still means a lower opening.

in short term

Index futures prices are usually an excellent indicator of the direction the market opens, but this signal only works for a short period of time. Trading at the opening of Wall Street usually fluctuates, which is a disproportionate proportion of the total trading volume. If institutional investors weigh large-scale buying or selling plans for multiple stocks, market influence may overwhelm any price changes shown by index futures. Of course, institutional traders do pay attention to futures prices, but the larger the order they must execute, the less important the direction signal of index futures is.

The late opening will also disrupt index arbitrage activities. Although most trading on the New York Stock Exchange starts at 9:30 a.m. Eastern Time, not every stock starts trading at the same time. The opening price of some stocks is set through a bidding process. If the buying price and selling price do not overlap, the stock will remain closed until a matching order comes in. Index arbitrage players will not step in until they can execute their two-party trades, which means that the largest-and preferably all-stocks in the index must open. The longer index arbitrageurs stay on the sidelines, the more likely it is that other market activities will negate the direction signals of index futures.

Bottom line

If S&P 500 index futures rise outside the trading hours and imply that the stock market is rising at the opening, investors who wish to sell on the same day may have to wait until the market opens before placing an order (or set a higher price limit). When index futures also Buyers may wish to postpone the forecast when the opening is low. However, nothing can be guaranteed. Most of the time index futures can indeed predict the direction of the opening market, but even the best fortunetellers can sometimes make mistakes.

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