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The Big, Bad Q&A On Index Futures

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July 1, 2013
how to trade index futures
Fredrik Broden

Now I know what you're thinking. Futures? Don’t those end up as truckloads of grain in your driveway? Don’t crazy people use futures to try and corner the global orange juice market? Maybe you’ve read about them in the press, and they sound interesting but way too confusing and scary. Here you’ll get to know futures without the drama. They’re not for everyone, but they can be pretty useful in certain scenarios. In fact, an overwhelming majority of trades placed by your peers with TD Ameritrade accounts are index futures. And the best place to start is with stock-index futures, some of the largest benchmark indices you may already know a little bit about.

What’s an index future anyway?

Futures are contracts between a buyer and a seller, authorized by an exchange like the Chicago Mercantile Exchange, to deliver a product, or cash value, at a predetermined future date for a specific price. In the case of stock-index futures, they are cash settled—meaning they turn into cash when they expire in the value of the index price itself. And that’s important. Futures go up and down in price when the index on which the future is based, like the S&P 500 or NASDAQ 100, goes up and down as well. Consider the U.S. market’s four main equity-index futures:

1. S&P 500 futures (symbol /ES)

2. NASDAQ 100 futures (symbol /NQ)

3. Dow futures (symbol /YM)

4. Russell 2000 futures (symbol /TF)

Expire? You mean I can’t buy and hold index futures like stocks?

Unlike stocks, each index future has an expiration date when it stops trading and turns into cash. The dates for the four main index futures are the third Friday of March, June, September, and December. You can buy and sell the futures up to that date when trading stops for those futures in a given expiration. If you’re long a future that’s approaching expiration, and you want to maintain a position, you could “roll” the future into the next expiration by selling the future you own, and buying the future in the next expiration month.

How do I see the prices for these index futures?

Each future has a symbol that lets you see a live quote on TD Ameritrade’s thinkorswim® platform. They all have a “/” in front of them. Type the various symbols on the Trade page, the Charts, or a Watch list, and you’ll get a quote for that future.

Why is the S&P 500 futures price not the same as the S&P 500 index price?

Because of “cost of carry,” the E-mini S&P 500 future (/ES) is not the same price as the S&P 500 cash index (SPX). It would cost a lot of money to buy all 500 stocks in the S&P 500 index in the correct number of shares. And to get that money you’d likely have to borrow it and pay interest, or use savings and lose interest. Either way, owning all that stock costs interest.

On the other hand, those stocks might pay dividends which might help offset some of the interest charges. The future doesn’t have any interest charges or receive dividends. So, if you have a choice of buying 500 stocks and paying interest and receiving dividends, or buying the future, you might prefer the future. That’s why the future is typically more expensive than the cash index.

The difference is the net between the interest cost of owning all the shares and the dividends. Traders tend to be willing to pay extra for the future to avoid the cost of carry. You can see this by comparing /ES to SPX, /NQ to NDX, /YM to $DJI and /TF to RUT, which are the symbols for the stock indices themselves.

How much stock do these index futures represent?

If you think of an index like the S&P 500 as a portfolio, the value of the portfolio that the /ES future represents is $50 times its price. That $50 is the value of a $1.00 point in the /ES, and the point value of other futures is different (Table 1). So, f /ES is trading The Anti-Index at $1,500, it would represent an S&P 500 portfolio worth $75,000. That may sound like a lot But if you have a stock or fund portfolio with a high correlation to the S&P 500 that’s worth $75,000, your account would represent the same amount of value as one /ES future.

TABLE 1: THE FOUR BIGGIES. If you’re trading index futures, you’re probably tracking or trading at least one of these four. But not all indices trade alike. So be sure to understand the point value, minimum tick, and margin required for each before diving in. For illustrative purposes only. Not a recommendation of any security.

How is the profit and loss calculated on a stock index future?

Like a stock, profit or loss is based on the difference in value between the price for which you buy and sell the future. But while options on stock are always $100 a point, index futures are not. For example, the E-mini S&P 500 future has a $50 point value. You multiply that point value by the difference between the trade price and the current price. If you bought a /ES future for $1550.00 and now it’s trading at $1560.00, your account would show $500 profit, less transaction costs, of course.

How do they come up with the margin requirements for stock-index futures?

Like anything else, you need money to buy a future. But you don’t really “pay” for the future like you’d pay for stock. The money you put up when you buy a future is known as the initial margin, a sort of good-faith deposit. The margin covers a possible negative change in value of your futures position from one day to the next.

The margins are based on the exchange’s estimate of how much the one-day change in value of the future might be. For the E-mini S&P 500 future, the margin is $3,850 (Table 1). That’s the amount the CME feels would cover the potential one-day value change in the future, about 5% of the value of the /ES. Note that margins aren’t fixed. The exchanges can increase or decrease the margin requirements for futures at any time.

How do I use index futures to protect my stocks?

Experienced traders often use index futures such as the S&P 500 (/ES) as a hedge against a large, diversified long-stock portfolio. If you’re concerned about a sell-off in the market, and you qualify for tier 2 option approval, you could consider using a short /ES future, for example, as a hedge. If the market does drop and your stocks lose money, the short /ES future might make you money to help offset the losses. Of course, if the market rallies, your short /ES would lose money and offset profits.

Also, index futures can be an efficient use of capital because they offer leverage. For the /ES, a $3,850 margin is a small amount of money with which to buy a future worth, say, $75,000. If you were going to buy, say, $150,000 of a stock portfolio, you might consider buying two /ES futures instead. There’s more to learn before you do this, however, like commissions, margin calls, and rolling through expirations. And don’t forget that while leverage can lead to greater returns, it can also lead to greater risk of loss.

At this point, you should have a good handle on the basics of stock-index futures. You can see futures quotes but you need a futures account to trade them. To apply for futures trading at TD Ameritrade, you must have margin trading enabled, options trading tier 2 or higher and a minimum net liquidation value of $25,000 or more. When it comes to expanding your trading strategy, consider letting the future(s) be your guide!

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