WHAT ARE INDEX FUTURES?

The equity index future is a future contract based on the equity index, such as S&P 500, NASDAQ, and Dow Jones indices. It is calculated by adding the cost of carry, which is equal to the interest, and then subtracting the dividend payment from the current stock index. It is the best estimate of the future stock index, and provides great hedging and trading opportunities.

The most important and most watched index futures are traded on the CME in the US. The S&P 500 is the most important of all indicies, followed closely by the NASDAQ 100 and even more distantly by the Dow Jones 30. In Europe, the Dow Jones Eurostoxx 50, the FTSE 100, and the DAX 30 are the most closely watched. Outside of Europe there are a handful of indices worth keeping tabs on including those in Hong Kong, Japan, Australia, and Russia. But most of the world’s index traders are focused on Europe and the US.

When a significant event happens, people enter the futures market first to buy or sell the index futures, and then the stock market follows. For example, at the time when Microsoft waited for the court decision on its anti-trust case, the trading of its stock was halted. When the decision came out and while the trading of its stock was still suspended, people rushed into the NASDAQ futures market to hedge their positions in Microsoft. In the stock market, there are restrictions on the short sale of stocks and when the market is bearish people have fewer opportunities to hedge, except through selling index futures since the futures market treats buying and selling equally.

In the United States, the stock index futures market is open nearly 24 hours a day, except for half an hour’s break. In contrast, the stock market only opens from 9:30am to 4:00pm. Though there is an out-of-hours market for stocks, only the big-name stocks such as Microsoft and Cisco have liquidity during these hours. Therefore, if any news comes out at night, investors can trade index futures to hedge or speculate on those less liquid stocks.

Many mutual fund managers use the index futures to manage their customers’ assets. For example, imagine that a fund manager receives a call from a customer who would like to send him two million dollars to invest in the stock market in one month. However, the customer is quite bullish about the market and is afraid that he may have to pay higher prices to buy stocks after one month. The fund manager can then buy one-month index futures contracts to lock in the initial price. No matter what happens, the customer can be guaranteed of the option of buying the index, or the portfolio of the index component stocks, at the price specified in the futures contracts after one month.

In 1999, one of the best years for the U.S. stock market, statistics show that nearly half of stock investment funds could not beat the return of the S&P 500 index after their management fees. That means, if someone just bought the S&P 500 index future and held it for the year, you would have got more than 20% annual return without paying attention to selecting high-performance stocks. Therefore, investment in the index futures is a very cost-effective method.

Furthermore, since the stock index is equivalent to the capital-weighted average of component stocks, buying index futures is just like buying a portfolio of the stocks but incurs lower commission fees. Therefore, trading index futures is a very efficient way to trade the whole market.