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What are index futures?

Index futures are financial derivatives that allow investors to buy or sell a contract based on a financial index at the present time, with the settlement taking place on a future date. Initially designed for institutional investors, index futures are now accessible to individual traders as well. These futures contracts serve multiple purposes, including speculation on the price movement of various indexes such as the S&P 500 and the Dow Jones Industrial Average (DJIA), as well as hedging equity positions against potential losses.

Understanding Index Futures

An index represents the price performance of an asset or a group of assets, such as stocks, commodities, or currencies. On the other hand, a futures contract is a type of financial instrument that requires traders to buy or sell the underlying asset on a predetermined date at a specified price. In the context of index futures, traders enter into a legal agreement to buy or sell a contract derived from a stock market index by a particular date at a predetermined price.

Index futures, also known as stock or equity market index futures, function similarly to other futures contracts. They provide traders with the rights and obligations to settle the cash value of the contract based on an underlying index at a predetermined future date and price. If the contract is not offset through a corresponding trade before expiration, the trader is obligated to deliver the cash value on the expiry date.

Traders utilize index futures to hedge or speculate on future price fluctuations in the underlying equity index. For example, the S&P 500 Index monitors the stock prices of 500 major U.S. companies. An investor can engage in buying or selling index futures on the S&P 500 to hedge or speculate on potential gains or losses of the index.

Types of Index Futures

The most popular index futures are typically based on equities, allowing investors to place their bets on specific indexes mentioned in the contracts. For instance, traders can invest in the S&P 500 index by purchasing E-mini S&P 500 futures contracts. Similarly, investors have the option to trade futures for the Dow Jones Industrial Average and the Nasdaq 100 Index. These include contracts such as E-mini Dow, E-mini Nasdaq-100, Micro E-mini Dow, and Micro E-mini Nasdaq-100.

Outside the United States, futures contracts are available for indices like the DAX Stock Index, which represents 30 major German companies, and the Swiss Market Index, both traded on the Eurex. In Hong Kong, Hang Seng Index (HSI) futures enable traders to speculate on the market's major index.

Different products may employ various multiples to determine the contract price. For instance, the E-mini S&P 500 futures contract traded on the Chicago Mercantile Exchange (CME) has a value of $50 multiplied by the index value. If the index trades at 3,400 points, the contract's market value would amount to 3,400 x $50, equivalent to $170,000.

Index Futures and Margins

Unlike traditional investments, futures contracts do not necessitate the buyer to deposit the entire contract value upfront. Instead, they only require the buyer to maintain a fraction of the contract amount, known as the initial margin. It serves as a "good faith" deposit when entering a trade.

The prices of index futures can experience significant fluctuations until the contract's expiration date. Therefore, traders must have sufficient funds in their accounts to cover potential losses, referred to as the maintenance margin. The maintenance margin represents the minimum amount of funds that an account must hold to meet any future claims.

The Financial Industry Regulatory Authority (FINRA) has set the minimum account balance requirement at 25% of the total trade value. However, some brokerages may demand a higher percentage. As the trade value increases before expiration, brokers can request additional funds to be deposited into the account, which is known as a margin call.

It's important to recognize that index futures contracts are legally binding agreements between the buyer and the seller. Futures contracts differ from options since a futures contract is an obligation, whereas an option is a right that the holder may choose to exercise or not.

Profits and Losses from Index Futures

An index futures contract entails the holder's agreement to purchase an index at a specified price on a predetermined future date. Index futures contracts generally settle on a quarterly basis, such as in March, June, September, and December, with several annual contracts available as well.

Equity index futures are cash-settled, meaning there is no physical delivery of the underlying asset at the contract's end. If the index price is higher than the agreed-upon contract price at the expiry date, the buyer realizes a profit while the seller, known as the future writer, incurs a loss. Conversely, if the index price is lower, the buyer experiences a loss, and the seller generates a profit.

The profit or loss resulting from index futures is determined by the difference between the entry and exit prices of the contract. Similar to any speculative trade, there are inherent risks involved, as the market can move against the trader's position. As mentioned earlier, the trading account must meet margin requirements, and a margin call may be issued to cover potential further losses. Traders must understand that numerous factors influence market index prices, including macroeconomic conditions like economic growth and corporate earnings.

Index Futures for Hedging

Portfolio managers frequently employ equity index futures as a means of hedging against potential losses. If a manager holds positions in a large number of stocks, index futures can help mitigate the risk of declining stock prices by selling equity index futures.

Since many stocks tend to move in the same direction, a portfolio manager can sell or short an index futures contract in case stock prices decline. In the event of a market downturn, the stocks within the portfolio may decrease in value, but the sold index futures contracts would appreciate, offsetting the losses from the stocks.

Portfolio managers have the flexibility to hedge either the entire downside risks of the portfolio or partially offset them. However, hedging reduces profits if the hedge is unnecessary. Therefore, if an investor holds a September futures contract and shorts index futures while the market rises, the index futures' value would decline, offsetting gains in the portfolio as the stock market rallies.

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