S&P 500 futures can provide traders with exposure to the individual companies that make up the S&P 500 Index. But trading futures is different from trading equities. Understand how they work and how you can trade S&P 500 futures.
Scan the lineup of global equity benchmarks, and you’d be hard-pressed to find anything that packs the wallop or sets the tone like the S&P 500 index (SPX). Representing U.S.-based companies with a combined value of $27 trillion, the S&P 500 index is the ultimate measuring stick for thousands of funds and fund managers. Yet, for individual investors and traders, taking or unloading a position in specific S&P 500 index companies may not always be feasible or desirable. Fortunately, there’s another way: S&P 500 futures.
Futures based on the S&P 500 and other equity indexes “can be a helpful tool to gain exposure to the broader market, protect against market turmoil, and add portfolio flexibility during earnings season,” said Adam Hickerson, Director, Charles Schwab Futures and Forex LLC.
The E-mini S&P 500 futures have been traded for more than two decades. More recently, smaller, Micro E-mini S&P 500 contracts have presented new potential opportunities for qualified retail investors and traders. Still, “futures are different from stocks in many ways,” Hickerson said. “Futures trading involves substantial risk and is not appropriate for everyone, so it’s critical to understand how futures work and be aware of the opportunities and risks before trading.”
Let’s go over the basics of how to trade S&P 500 futures.
What is a futures contract and how do futures differ from stocks?
A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Futures contracts are bought and sold mostly electronically on exchanges and open for trading nearly 24 hours per day. Trading futures requires opening an account with a registered broker, much as you would to trade stocks. Unlike shares of stock, which in theory can be held forever, futures contracts “expire” in a specified month.
Commodity futures based on grain or crude oil offer the potential for “physical delivery”, wherein the buyer takes possession of the commodity (and the seller must deliver the commodity). In contrast, equity index futures like the S&P 500 contracts are “cash settled”, meaning a cash position is transferred between the buyer and seller.
Among the many futures contracts, why trade S&P 500-based futures?
Traditional E-mini S&P 500 futures, along with the newer Micro E-mini futures, are based on the underlying S&P 500 Index and closely track the U.S. benchmark from day to day. The E-mini and Micro E-mini S&P 500 both trade on Chicago-based CME Group exchange and are among the most actively traded futures in the world. So, typically, there’s ample “liquidity” for buyers and sellers to find each other and quickly and efficiently execute trades, according to Hickerson.
“Many professional portfolio managers and traders use S&P 500–based futures to hedge against potential market downturns or insulate their portfolios against surprise events,” Hickerson added.
During the first six months of 2020, trading in E-mini S&P 500 futures averaged 2.31 million contracts per day, up 43% from the same period in 2019, according to CME data. Trading in Micro E-mini S&P 500 futures, which are one-tenth the size of the traditional e-mini contract, averaged 851,928 contracts per day, a fivefold increase from 2019 (Micro E-mini contracts were launched in May 2019).
What’s the difference between E-mini S&P futures and Micro E-mini S&P futures?
“Smaller bite” micros require less money up front and can be less expensive to trade compared to traditional e-minis, according to Hickerson. For example, the “maintenance margin”—the minimum amount of money a trader must maintain after opening a position—for one Micro E-mini S&P 500 futures contract (/MES) was $1,200 in July 2020. For the E-mini S&P 500 contract (/ES), the maintenance margin was $12,000 per contract.
The “multiplier” used to determine the notional value for Micro E-mini S&Ps, at $5, is also one-tenth the size of the E-mini S&P contract. If the S&P 500 index is trading at 3,000, one Micro E-mini S&P 500 contract would be 3,000 times the $5 multiplier for a notional value of $15,000. The notional value of the E-mini S&P 500 would be $150,000 (3,000 x the $50 multiplier).
How can trading S&P 500 futures help hedge a portfolio and maximize portfolio efficiency?
S&P 500 futures and other equity index–based futures offer a possible tool to boost “capital efficiency” and hedge against market volatility.
One futures-based hedging approach involves calculating “beta” and “beta weighting” (beta measures the volatility of an individual asset, or an entire portfolio, in comparison to a benchmark such as the S&P 500 index). Through beta weighting (available on trading platforms such as the thinkorswim® platform), you can gauge your portfolio’s risk relative to the S&P 500 or to a single asset, according to Hickerson. (To beta weight, you first determine “delta”, a measure of sensitivity to a dollar change in the underlying asset.)
If the broader market falls or rises X number of points, you can gain a theoretical sense of what such moves would mean for your portfolio balance. You can beta weight your entire portfolio, “effectively gaining a window into what your portfolio would do if there’s an increase or decrease in the overall stock market,” Hickerson said.
Here’s a simplified futures-based hedge example. Suppose you hold a stock position or a portfolio of stocks with a value of $50,000, and you’re concerned about the prospect of negative surprises in upcoming economic reports or earnings season.
You could hedge about 30% of that portfolio by selling (or shorting) one Micro E-mini S&P 500 contract by putting up the $1,200 maintenance margin, or about 8% of the $15,000 notional value of one Micro E-mini S&P 500 contract ($5 x 3,000, using the numbers from the previous example).
If the S&P 500 drops 50 points (about 1.7%), you could then buy back, or “close out”, that futures position and pocket a gain of more than $200 that could help offset any paper losses in your stock portfolio. By taking a position in the futures contract, you gain similar notional exposure while tying up a lot less capital.