This article discusses the basics of futures in financial markets and its type which is known as index futures. If you wish to explore Index futures and how to utilise the same, then this article will serve your purpose well.
Going forward, we will discuss Index Futures, and this article covers:
- What are futures?
- Index Futures: what and why?
- Working of index futures
- How do index futures predict the market?
- Calculation of future price
- Ways to trade index futures
What are Futures?
Futures, in financial markets, imply the contracts that obligate the holder to trade an asset at a predetermined price on a fixed date in the future. The two parties involved in it are the buyer and the seller of the asset. On the expiration date, the buyer must buy and the seller must sell the asset. They settle the contract always in cash.
On the date of settling the contract, they exchange the difference between the current price in the market and the price determined in the contract. This difference is the profit for the seller (in case the price goes down) or loss (in case the price goes up).
Futures contracts originated for those commodity manufacturers or producers who needed a guarantee of their price much before the sale would happen. Gradually, over a period of time, they started being used as Derivatives.
Okay! Going forward, we will look at what and why part of index futures.
Index Futures: What and Why?
Index Futures is nothing but a type of Futures contract which is used for trading stock indexes. Holding or buying an Index Future contract implies that you have agreed to trade a specific stock index at a predetermined price and date. Also, since there is no underlying physical asset to trade or deliver in the stock market, Index Futures are settled in cash.
Why Trade Index Futures?
Since trading Index Futures has its own advantages, we will take a look at them here. There are three main reasons you can trade Index Futures, and they are:
- Speculation
- Hedging
- Capital-building
Speculation
With an Index Futures contract, you can speculate the value of the same and decide the investment on the basis of speculated value. This way you can go short or long with cash settlement.
Hedging
With the Index Futures, you can hedge your stocks by holding multiple stocks. When you hold multiple stocks for trading on Index Futures, you can offset the risk of losing by shorting the Futures contract.
Capital-building
You can get a good position as a holder of the capital since with Index Futures, apart from the advantages mentioned above, you can also leverage the contract. Leverage implies that you can loan out the funds for holding Futures. This way, you can build-in capital if you speculate and invest well.
Let us move forward, and see the working of index futures now.
Working of Index Futures
Stock Index Futures work by trading against both the major (like DJIA, SPY) and small as well as mid-cap stock indexes. Interestingly, the most popular stock indexes are of different sizes, which means that they are worth the different amounts.
Let us take a look at the working of Index Futures. You can trade Index Futures in two ways, and hence, they can be traded by:
- Hiring a broker
- Index Contract For Difference or CFDs (Direct trade with the exchange)
Hiring a broker
Index Futures are traded on exchanges exactly how shares are traded. Futures exchanges work very much like the stock exchanges and thus, they are strict with regard to who can access their order books. For buying and selling the Futures, you may need a Futures broker.
Index Contract For Difference (CFDs)
This implies that you are allowed to deal directly with the exchanges and make the investment decisions on the basis of future prices of contracts. This way, you do not require a broker’s intervention and you can trade with a leverage (loan) provider. Although CFDs are leveraged, they come with the risk of losing the entire amount of money.
Moving forward, we will take a look at how the index futures help to predict the market.
How do Index Futures Predict the Market?
Index Futures do help predict the market, but they should not be your sole source for doing so. For predicting the market with the help of Index Futures, you need to look into the movement of traders. In case the traders are ready to sell lots of Futures Contracts but at a lesser price than last day’s closing price, it implies that the market may be slumping. Conversely, if traders are buying a lot of future contracts, it may be hinting at the market going up.
Even though this analysis plays an important role, it may go wrong occasionally. Also, there is a possibility of the market shifting entirely during the course of the day. This is possible due to certain factors like:
- Positive or negative feedback regarding the products of the company
- Some glitch in the functioning of the firm
- Economic events like Recession
- Negative outcomes for a particular industry because of an economic situation
That is why you need to keep a close check on the rest of the factors also while predicting the market.
Now, let us see how to calculate future price or value of index futures contract.
Calculation of Future Price
Let us take a look at the Python code that will help you analyse the value of futures contract in a given number of years or in the future. On the basis of this value, an investment decision can be made.
The formula to find out the price of Futures Contract are based on factors like:
- Rate of interest
- Time to expiry
- Profit margin expected
- Spot price
- The financial cost of the Futures Contract
Formula:
Future Price = Spot Price(1+r)t - Dividend expected (1+r)t + Cost (1+r)t
Here,
Spot Price = Current price of the stock
r = Rate of interest
t = Time to maturity
Cost = Charges of holding the stock
In Python, there is an extremely simple code that you can use for calculating future price of the Index Futures Contract, so as to base your trading decision on the same.
Output:
761.22
Running the code above gave us the output as 761.22 which is the expected future price or value based on the information we fed the system with. As we can see that the market is expected to perform better in the future we can go long on the stock. Also, this means that the market is expected to go up.
Let us find out ways to trade index futures next.
Ways to Trade Index Futures
In case you are buying or selling contracts themselves, you can use a Commodity Futures Broker, who helps facilitate the trade on both buy and sell orders. In case of Index Futures, like the traditional stock market trading, the “buy” positions give profits to the investors from the rising market, whereas, the “sell” positions provide profits from the falling stock market.
You can trade the Index Futures in two ways apart from trading with your own funds. The two ways are:
- Leverage
- Going Long or Short
Leverage
Leveraging means you are trading with the borrowed funds for going up in both position size and profitability. Hence, leverage is nothing but the amount by which position of yours, as a trader, goes up since you hold stocks of more value than you would have with your own funds. This also means that you will fetch more gains in case the market goes up. Conversely, there can be losses in an otherwise scenario.
For instance, you are investing in an Index Futures contract partly with your own, say, $100 and partly with the loan or leverage money, say $100. This makes your position be at $200, instead of $100, which would have been in case you did not take in the loan money. Now, in the future, on the expiration date, if the value of the stocks rises, then you will be pocketing more than you could with only $100 worth the stocks. Since you will be getting the difference between the current market price and the determined price on the contract, it can be worth a lot in case price or value rises to a good extent.
Going Long or Short
Going short implies selling of stocks or securities, which are not currently owned by the investor, in the hope that the prices may decline in the future. Whereas, going long implies owning the stock or security since you are optimistic about the price increasing. When the price of an Index Futures contract is expected to fall (going short), or to rise (going long), the difference between current and future price tends to maximise your gains.
Also, you can try this course on short selling and for reading more on short selling in trading, please refer to the blog here.
Okay! This brings us to the end of the article and hopefully, it helped understand some of the significant uses of Index Futures.
Conclusion
In this article, we discussed some basic aspects of Index Futures and how the investment in the same can be worth it. Working of index futures consists of two options. One is to trade via a broker and another is to trade directly with the exchange. Also, it is really simple to speculate the future price and trade on the basis of the same. You predict the futures price in Python and trade either by leveraging or by going long or short.
If you want to know about how to execute a strategy for large trade orders, check out our blog on TWAP an execution strategy in detail .
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.
