What are Index Futures?

Investors can use a variety of stock market instruments to profit from speculation on future asset movements. An index futures contract is a financial instrument that you can use to speculate on the price movements of major stock market indexes, including the S&P 500 or the Russell 2000. 

Once open only to institutional investors, you can now take advantage of index futures movements as a retail investor. Read on to learn more about index futures and how to get started trading them. 

How do Index Futures Work?

Index futures contracts are a type of futures contract that speculates on price movements of major stock indexes. Like futures contracts designed to represent price movements of commodities, an index futures contract provides the investor with the opportunity to benefit from both positive and negative price movements. 

Before covering the specifics of index futures and trading strategies, let’s define what these contracts are and how they work. Futures contracts are financial instruments that require investors to buy or sell an underlying asset at a specific price at a specific date in the future. Indexes are stock market measures that track the price movement of a particular group of assets. An index future is a contract that requires traders to buy or sell an equity contract derived from the underlying index. 

Index futures (sometimes also referred to as equity index futures from the underlying contract requirement) function in the same way as commodity futures contracts. For example, you might believe that the S&P 500 index will increase in value. In this instance, you may take a long position and purchase a contract at the current index value. 

If the index rises in price, the value of the contract will also rise. The profit or loss is calculated based on the difference between the futures price at the time of purchase and the settlement price. Market participants are typically required to settle futures contracts at the expiration date in cash. The settlement price is determined using the actual equity index value on the expiration date.

Margin

Before purchasing a futures contract, your broker will require that you make a margin deposit into your account proportional to the contract size. The margin deposit required will usually be structured as a percentage value of the contract you purchase. 

Margin requirements serve as a form of collateral to cover potential losses that may arise from price movements that don’t follow your predictions. By requiring traders to deposit a margin, exchanges and clearinghouses ensure that participants have sufficient funds to fulfill their financial obligations. This keeps the futures market safe for participants and prevents drastic, sudden losses. 

Futures contracts also usually offer leverage, which means that a relatively small margin deposit controls a larger contract value. This amplifies potential profits and losses. Margin allows traders to participate in the futures market with a fraction of the total contract value, thereby increasing their exposure and potential returns. However, it's essential to recognize that leverage also magnifies risk, as losses can exceed the initial margin deposit. You might also run into the risk of a margin call, which is covered in more detail in the section detailing risks. 

Profit and Losses

Index futures contracts allow holders to agree to purchase an index at a specified price on a future date, settling quarterly or annually without physical delivery of the underlying asset. If the index price exceeds the contract price at expiry, the buyer profits while the seller (future writer) incurs a loss, and vice versa. 

Profits are determined by the price difference at the time of expiration, but margin fees and commissions can take a chunk of your profits. Be sure to consider account fees in your risk-reward calculation to determine if futures trading is right for your risk preferences and trading strategy as an investor. 

Hedging

Some investors hold index futures contracts as a hedge against potential downturns in the market. Hedging involves purchasing assets that are likely to rise in value if the investor’s portfolio decreases in value. This may help retain your total net worth, even in a bear market. 

To hedge against market declines, investors take a short position in equity index futures. This involves selling futures contracts on the index with the expectation that their value will decrease if the market declines. When the index declines, the value of the futures contracts tends to rise. Therefore, if your portfolio experiences losses from market downturns, the gains from the short position in the futures contracts can help offset those losses.

Speculation

Speculation is an advanced futures trading strategy where traders aim to predict how an asset will move in the short term. In this instance, speculators take a position in index futures that aligns with their market outlook. If they believe the index will rise, they take a long position by buying futures contracts. Conversely, if they anticipate a decline, they take a short position by selling futures contracts. Once the trader’s position is in the money, they exit and take profits. Speculators usually do not consider the long-term health of the underlying asset. 

Speculation aims to capitalize on short-term price movements by entering and exiting positions at opportune times to maximize profits. Speculators may hold positions for hours, days or only a few minutes, depending on their trading style and strategy. This trading strategy is usually reserved for more experienced traders who know how to consistently and accurately read indicators. 

Types of Index Futures

There are various types of index futures, each of which tracks a unique stock index. Some of the most common types of index futures you can trade include the following. 

• Dow Jones Industrial Average (DJIA): The DJIA represents 30 of the largest and most important companies in the United States. Some of the largest components of the index include Nike, Microsoft and Boeing. 
• S&P 500: The S&P 500 is one of the most common stock indexes referenced in futures trading, representing 500 of the biggest domestic companies when measured by market capitalization. 
• NASDAQ-100: The NASDAQ 100 is made up of 101 components composed of the largest non-financial companies listed on the NASDAQ. Some major components of the index include NVIDIA, Netflix and Intel. 

Considering the specific index you’re trading futures for is a particularly important consideration when speculating for short-term profits. 

Index Futures vs. Commodities Futures Contracts

If you’ve traded futures contracts in the past, they were likely commodity contracts. Commodity futures contracts are the most common asset traded on the futures market, representing an underlying commodity that can be bought and sold. Examples of common commodity futures products include wheat, corn and sugar. The value of commodity futures is derived from the supply and demand dynamics of the underlying physical commodity.

Index futures do not derive their value from a commodity that the contract is tied to. Instead, the value of the contract is based on the underlying value of the index compared to the original value of the contract. There is no physical transfer of assets involved in an index futures purchase, which is not always the case for commodities futures. 

Benefits of Trading Index Futures

Trading index futures allows you to profit from positive and negative index movements. As many of these indexes have retained value relatively consistently when compared to individual stocks, trading index futures may be a less risky way to get started learning about futures trading. 

• Leverage: Futures trading allows investors to compound trade results using leverage, which is easily accessed after being approved for futures trading by your broker. 
• Liquidity: Index contracts may be more liquid than commodity contracts because they do not involve the physical delivery of a product at any point in the asset’s life. 
• Diversification: Indexes include a number of underlying assets from which they derive value. This diversification means investors are less likely to see sudden losses. 

Risks Involved in Index Futures Trading

Futures trading also comes with potentially very expensive risks.

• Margin calls: Margin calls occur when your account value falls below the required margin level, prompting you to deposit additional funds to maintain the position. Failure to meet margin calls may lead to forced liquidation and potential losses. 
• Price volatility: Futures contracts are highly speculative assets, making them more volatile. Higher volatility increases the potential for profits and losses, making it important for you to take steps to manage risk and be prepared for sudden market movements.
• Counterparty risk: Counterparty risk refers to the possibility that the counterparty (usually the clearinghouse or the other party in the trade) may default on their obligations, leading to financial losses or disruption of the trading process. Be sure to trade with reputable and regulated entities to mitigate counterparty risk.

Best Brokers for Trading Index Futures

The broker that you choose to trade index futures will determine the types of assets you can invest in, as well as fees. Benzinga offers insights and reviews on the following futures brokers. Consider continuing your education with a few of the links below. 

Is Trading Index Futures a Good Idea?

The decision to trade futures is a personal one. Index futures can provide a unique level of diversification to your portfolio while also introducing a higher liquidity level. Major market index futures tend to be bought and sold frequently throughout the day, leading to fewer liquidity concerns. Still, it’s important to remember that leverage and margin calls can compound a trader’s losses quickly, meaning that index futures are best traded using a solid trading strategy.

Frequently Asked Questions