What Are Index Futures, and How to Trade Them Profitably
If you’re like us, then you check some financial news outlets when you wake up – hours before the exchanges open. That means there isn’t much to talk about in the stock market. So instead, the early-morning shift of financial journalists tends to focus on stock index futures.
These derivative instruments might sound dauntingly technical. But they represent a very simple concept. And they’re a great way to learn about derivatives trading, which can boost your portfolio’s upside and protect you from market uncertainty.
Let’s learn how to use stock index futures to expand your upside and safeguard your portfolio.
What Are Index Futures?
Before we get into index futures, it might help to review what a futures contract is.
Suppose that you’re a coffee farmer, and you’re selling your produce in the global coffee market. Normally, you get about $2 per pound. But there are lots of factors affecting the market price of coffee. If favorable weather creates a big harvest, for example, then supply could overwhelm demand and crash the price to $1 per pound.
As a hardworking farmer, you need a consistent income. So instead of putting yourself at the mercy of the coffee market, you sign a futures contract with a coffee trader. The trader agrees to buy 100 pounds of coffee for $200 at some time in the future.
That way, you get a guaranteed price of $2 per pound for your hard work. And the coffee trader can sell that contract for a big profit if the price of coffee goes above the guaranteed price. But they also risk shouldering the loss if the price ends up below that mark.
Before the 1980s, almost all futures contracts were like this example. They dealt with agricultural products like coffee or grain that had volatile market prices. But then, in 1982, CME Group (Nasdaq: CME) invented the stock index future.
Instead of tracking the price of coffee or other commodities, index futures track the Dow, the S&P 500 or another major stock index. These futures contracts give the owner the obligation to buy a given number of index shares at a given price at a given time in the future.
If the market trades above that price, then you can sell your index futures for a profit. If the market goes below that price, then you’re running a loss on those contracts.
Now that we’ve learned what index futures are, let’s go over how to make money trading them.
Index Futures Trading Strategy
The most popular instrument for index futures trading is CME Group’s E-Mini S&P. As the name implies, it’s a small futures contract for 50 shares of the S&P 500 index. That might not exactly sound “mini,” but it’s much more accessible to individual investors than regular S&P contracts. They’re often for 500 shares of the index, which can cost millions of dollars.
E-Mini S&P contracts trade on CME’s Globex electronic trading platform, but you can buy them through most brokerages. They generally trade under the ticker symbol “ES” and include a month and year of expiration (at which point the contract owner must buy the underlying stocks).
For an investor who’s new to derivatives trading, a simple strategy is best. You can make some very high-risk, high-reward bets with futures, but these are not for the inexperienced.
One simple strategy involves buying a long-term index futures contract at the market price during a downturn. Suppose, for example, that you bought a one-year S&P 500 future when the market was down 5%. Over the next year, the S&P 500 gains 10%. So, buying futures during a dip and selling them when the market recovers can generate a lot of upside.
As we mentioned earlier, index futures are derivatives. Rather than representing debt or fractional ownership in a company, they represent the change in price of an underlying asset. Derivatives are bets within bets. And for that reason, they’re not for the faint of heart.
If you don’t feel comfortable with the basics of stock trading, we implore you to check out more of our financial literacy articles. But if you’re ready to try your hand at index futures trading, follow a simple, tested strategy. With some luck, you’ll be supplementing your stock returns like a Wall Street pro.