12/22/2023

Understanding index futures, and how to use it

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Index futures, which are agreements between two parties to buy or sell an underlying index at a specified price on a specified date. They can provide insights into the direction the market will open, but even these predictions can be inaccurate.

March Standard & Poor’s 500 index futures, for example, reflect the anticipated value of the S&P 500 index at the end of March. But the actual market opening may differ from this expectation. Index futures are not equivalent to holding the stocks in the underlying index. Investors who buy index futures do not receive dividends from the stocks in the index.

The price of an index future is influenced by the index’s fair value, which is determined by the sum of the prices of the stocks in the index minus the expected dividends and other expenses. When interest rates are low, the difference between the price of an index future and the fair value of the index is often negative, indicating that the index future is less expensive than the fair value of the index.

However, it is important to note that many futures contracts close out well before expiration.

Fair value of index futures

Index futures contracts, while closely linked to the underlying index, are not identical in all respects. In contrast to investors who purchase the stocks in the index or exchange-traded funds that track the index, futures traders do not receive dividends from the index’s constituents.

The index futures price aligns with the value of the underlying index solely at expiration. At all other times, the futures contract possesses a fair value relative to the index, known as the basis. This basis reflects the expected dividends that the index investor forfeits and the financing costs associated with owning index futures compared to owning the underlying equities.

When interest rates are low, the dividend adjustment tends to outweigh the financing cost, resulting in a typically lower fair value for index futures compared to the index itself.

Index futures arbitrage

Even if index futures are fairly valued based on their underlying index, they may not trade at that price due to various factors.

Market participants use index futures for a wide range of reasons, including hedging against potential market swings, adjusting their asset allocation strategies, and speculating on market direction. Index futures are more liquid than the markets for individual index components. It makes them appealing to investors seeking quick changes to their stock holdings.

When index futures prices deviate from their fair value, an arbitrage opportunity arises. Index arbitrageurs actively monitor index futures prices and engage in trades to restore the price to fair value.

Major banks and securities firms utilize sophisticated computer models that track the ex-dividend dates for index components and incorporate companies. So, they borrow costs to assess the index’s fair value in real time.

Index Futures Trading Hours

Index arbitrageurs strive to keep index futures prices close to fair value, but their efforts are constrained to market hours. They employ a hedging strategy that involves simultaneously buying or selling index futures and the underlying stocks. However, this strategy is only effective during market hours, when both index futures and the underlying stocks are actively traded. Outside of market hours, index futures become less liquid. Index arbitrageurs are unable to effectively hedge their positions.

Index futures predict opening direction

Imagine positive news emerges from overseas during the night. For instance, a central bank cuts interest rates or a country reports unexpectedly strong economic growth. Local stock markets are likely to rally, and investors anticipate a stronger US market as well. If they purchase index futures, the price will soar.

However, as index arbitrageurs remain inactive until the US stock market opens, no one will counteract buying pressure, even if the futures price surpasses fair value. As soon as the New York Stock Exchange opens its doors, index arbitrageurs will jump into action. They execute trades to bring the price of index futures back in line with fair value.

 

What’s the result?

Index futures prices frequently provide valuable insights into the market’s opening trend, but this signal’s usefulness is limited to a brief period. Wall Street’s early trading hours are frequently characterized by intense volatility, accounting for a disproportionate portion of total trading volume.

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