Futures Education

Index Futures

Stock index futures are relative newcomers to the futures industry, but have become one of the most popular futures contracts among retail traders. Starting out in 1982, the first index futures contract tracking the Value Line Composite Index was traded on the Kansas City Board of Trade.
A stock index represents the broad market. Changes in the index reflect the price movement of many different stocks. Since it is literally impossible to deliver one share or fraction of a share of each of the underlying stocks tracked by an index, stock index futures are settled in cash.
Stock index futures do not constitute ownership of any of the underlying stock, and index futures traders cannot hold claim to any of the underlying stocks' dividends or ownership rights. For this reason, stock index futures trade can trade a discount or premium to the underlying index.
Each index represents an average value of the stocks that are listed in the index. The value of the index changes every time the price of any one of the stocks changes. The indexes vary in both their composition and method of calculation. Here are just a few of the major indexes traded by index futures traders:

Standard & Poor's 500 Index

The S&P 500 Index is a market value-weighted index of 500 large-capitalization stocks traded on the New York Stock Exchange, American Stock Exchange and Nasdaq National Market System. Because the S&P is capitalization-weighted, those stocks with the most shares outstanding at the highest prices will have the most influence on the index movement. The S&P 500 index, introduced in 1957, is known as the investment industry's benchmark for measuring portfolio performance.
The Chicago Mercantile Exchange introduced S&P 500 futures in 1982, and they originally traded at $500 times the cash index. As the market began to surge during the 1990s, the initial margin became too costly for many futures traders. In response, the CME decided to cut the contract's value to $250 times the index.

Nasdaq-100 Index

The Nasdaq-100 Index includes the top 100 non-financial stocks (both domestic and foreign) listed on the Nasdaq Stock Market. Stocks such as Microsoft, Intel, eBay, Dell, Cisco, etc. dominate the index, so it's frequently associated with the technology sector of stock investing.
Futures on the Nasdaq-100 began trading in 1996 with a value of $100 times the index. Like the S&P 500 Index, the value of the Nasdaq-100 rose dramatically during the 1990s, however, unlike the S&P, the contract value has remained the same.

Dow Jones Industrial Average

The Dow Jones Industrial Average is an index of 30 large-cap "blue chip" stocks traded on the New York Stock Exchange, accounting for about 20 percent of the market value of all U.S. equities. The index, first published in 1896, is the most widely quoted market indicator in newspapers, radio, television and electronic media throughout the world. Futures on the DJIA began trading at the Chicago Board of Trade in 1997 after heated competition between the Chicago exchanges for the rights to trade futures and options on products owned by Dow Jones & Co., which had remained reluctant to allow its name to be used in trading.
That has changed today, as the CBOT offers three different DJIA futures contracts with sizes tailored to different market participant needs. Its "big" DJIA futures contract has a value of $25 times the average, while its standard DJIA futures contract is $10 times the average, and the mini DJIA futures contract has a value of $5 times the average.

Mini-Index Futures

In addition to the standard index futures, the exchanges have opened up index futures trading to the masses by offering smaller, miniature versions of the index futures contracts. These smaller contracts, called mini index futures, are based on the major market averages and indexes such as the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100 and the Russell 2000.
Mini index futures have grown exponentially in recent years due to significantly reduced margin requirements and contract value multipliers.
One of the factors that draws so many traders to mini indexes is the remarkably low margin rates for traders who open and close their positions over the course of a single session. Day trading e-mini index futures now provides a great alternative to day trading stocks, which has become very expensive for the average retail trader who is required to have an account of at least $25,000
Mini index futures are not just for the day trader. They offer opportunities for a wide variety of trading and strategies. While regular full-size futures contracts often require exceptionally high margins for the average trader, the mini-sized versions of the same contracts can be traded for a fraction of the margin.
In addition to low margin requirements, the leverage for traders in mini index futures is quite attractive as well. With the mini Dow priced at $5 per point, for example, traders can make much more money on a 200-point move day-trading the mini-Dow than they could by trading the Diamonds, or options on the Diamonds, and they can do it with significantly less capital.
Trading mini index futures can also be a simpler and more straightforward process for many traders than trading individual stocks. This is especially true when you consider diversification. Since mini indexes track a particular stock index, you are naturally diversified over a basket of stocks. To achieve the same diversification in stock would require managing a portfolio of 20+ stocks. Traders find that specializing and focusing their trading to mini index futures leaves less room for error; your focus is on one vehicle, one set of prices, and one analysis.

Common Index Futures Trading Strategies

By now, you have probably gathered that trading futures is similar to any type of other of trading - your primary objective is to buy low and sell high. One difference with futures, however, is that it's just as common to sell short, to sell first, and then buy back later as it is to buy first, or go long. Mini index futures are no different. If you think the market index is going up, you simply establish a "long" (buy) position, and if you think index prices are going down, you initiate a "short" (sell) position.
Once you have established your futures position, you have three basic alternatives to close it out:

• Offset your position by taking an equal but opposite position (selling if you have bought; buying if you have sold). Most futures are offset in this way. You don't have to wait until the expiration date to complete your trade–in fact, few investors do.

• Wait until your contract expires, and then make or take cash settlement. Cash settlement is made according to a "Special Opening Quotation" (SOQ), a price calculated for each domestic stock index product. This means your account will be debited or credited, in cash, the difference between your purchase/sale price and the final settlement as determined by the SOQ. Of course, if you offset your position, this process doesn't apply.

• "Roll" the position over from one contract expiration into the next. If you hold a long position in an expiration month, you can simultaneously sell that expiration month and buy the next expiration month (known as a "calendar spread") for an agreed-upon price differential. By transferring or "rolling" a position forward you are able to hold it for a longer period of time. For example, if you are holding a March CME E-mini futures contract, you can sell the March futures before expiration and buy a June futures, thereby expanding the timeframe of the trade.

Let's go through a couple of examples of index futures trades to make sure you understand how they work. The two most common types of trades are the long index future and the short index future.