Stock Index Futures

The stock market index is composed of a basket of stocks that indicates the generic price fluctuations and volumes generated in the stock. These stocks must meet certain criteria, such as high market capitalization, strong liquidity, etc., in order to make up the index. As traders, hedgers, and speculators buy and sell futures and options contracts, they would also buy and sell contracts based on a variety of stock indices, largely for the same purposes.

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What are Stock Index Futures?

Stock index futures are contracts for cash-set futures that are based on the stock index. Often, they are referred to as Equity  Index Futures or merely Index Futures. This arrangement requires the contract to be purchased or sold at a specified time in the future. Often known as the crystal ball of the financial markets, they are bets on the direction the equities might take with the primary stock market indexes. These types of contracts allow the purchase/sale of a certain quantity of a particular stock at a predetermined price in the future.

How do they work?

A futures contract is an agreement to buy or sell the value of an underlying asset at a particular price on a future date. However, stock index futures are settled by cash on a daily basis which means that the investors or traders pay or collect the difference in the value on a daily basis. Since cash settlements are in effect, investors typically have to fulfill liquidity or income criteria to ensure that they have sufficient funds to cover their possible losses.

Use of stock index futures:

• Since they are good indicators of market sentiment, they could be used for a variety of reasons, such as speculation, hedging, and spread trading.
• They are used by speculating traders to anticipate the direction in which the market will move in the future. If the trader thinks the value of the index will increase, then they may buy the index and vice versa.
• If a particular index has several long positions, this can mean that investors assume that the index will increase in value.
• They can also be used for hedging. If a certain investor has a portfolio that is correlated positively or negatively with the index, other losses that the portfolio may face can be hedged by purchasing or selling index futures.

Pros:

• As stated earlier, without having owned the index, investors can speculate on prospective stock performance and leverage to securities trading in highly regulated markets.
• The investors need to pay much less than the quoted price for the actual stock market index tracked by the futures contract, which reduces cost.
• They just pay just a percentage of the transaction as a margin to trade significant funds.
• Stock index futures also assist gains to be made from the market index movements.

Cons:

• There is a high level of risk involved in buying and selling these contracts. High volatility of the market brings large profits but equally large losses.
• In order to invest in these futures, the investor needs a margin account with an initial margin to cover potential losses. With a margin account, a margin call is anticipated.
• Hence, cash is required in margin accounts for the fulfillment of potential margin calls.
• Hedging increases costs for fund managers and this may lead to a decrease in their overall profit

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Bottom line:

Stock index futures are contracts to buy and sell a stock index. They allow the investor to speculate without necessarily buying stocks. According to market uncertainty and high risk, the risk appetite of the investor should be weighed before engaging in these contractual agreements.

 

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

 

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