How to Use Index Futures

Conversely, if futures are plus 30 and fair value is plus 10, futures are above fair value and stocks may open higher. Market sentiment is fickle—if a company reports huge earnings, and the Dow Futures skyrocket, the odds are good that the stock market itself will rise as well. If an unexpected weather event shuts down major shipping lanes before the stock market opens, it could cause the Dow Futures to drop, because investors begin anticipating problems.

If you’ve ever listened to an early morning financial news broadcast, you’ve heard a reference to “futures” and how they affect the stock market before it opens. Investors follow the futures because it provides an indication https://www.dowjonesrisk.com/ of where stocks are headed at the opening bell. One of the most widely followed futures is the Dow Futures, whose underlying value is based on the Dow Jones Industrial Average, an index of 30 major U.S. companies.

Closing a Position

Before getting into the Dow Futures, it is important to understand the definition of a future. A future can generally be defined as a contract which stipulates the buying or selling of a specified commodity for a certain price at a specific point of time in the future. For example, if you opened the trade by buying five E-mini Dow contracts, you would close the trade by selling them with the same futures contract expiration date.

Market participants use index futures for many different purposes, including hedging, adjusting asset allocation through index futures overlay programs or transition management, or outright speculation on market direction. Index futures are more liquid than the market in the index’s individual components, so investors in a hurry to alter their equity exposure trade index futures—even if the price isn’t equal to fair value. Once banks and brokers calculate interest costs and dividends, they establish a fair value number, such as plus 10, for example. That means if the futures are plus 5 for the morning, and the fair value number is plus 10, then stocks could actually open lower.

1. Major economic reports that confirm an existing trend generally result in a sympathetic move in futures and a similar move by the cash market at the open.
2. This will likely hold through the close, as long as nothing occurs during the day to alter conditions.
3. Beware, though, that leverage cuts both ways, magnifying losses as well as gains.
4. The Dow Jones consists of 30 companies while the S&P 500 consists of 500 companies, so there is more diversification in the S&P 500.
5. This creates the possibility of stocks also falling once the opening bell rings.

That means that if a trader borrows money to buy stocks, he would not make as much money as if he had used cash. Since the likelihood of using cash for that large a purchase is low, the cost of borrowing is calculated in the fair value figure, which will diminish the actual futures value. The position you take on a trade is the purchase price you have agreed upon with the seller. Dow Futures contracts trade on an exchange, meaning that the exchange is who you deal with when you create your position (your price and contract) on the commodity.

If Dow Futures are currently trading at 6,000, for example, a single futures contract would then have a market value of $60,000. For every $1 (or “point” as it is known on Wall Street) the DJIA fluctuates, a single Dow Futures contract has an increase or decrease of $10. Once you know your trading platform, select a trading strategy and test it using a demo or trade simulator account. Only begin live trading with real money after you have a strategy that is consistently profitable in simulated trading. This is even more important when trading with highly leveraged instruments such as futures. Whether it is better to invest in the Dow Jones or the S&P 500 will depend on the specific investor, their investment goals, and their risk tolerance.

Adding Dividends

This can allow traders to make substantially more money on price fluctuations in the market than they could by simply buying a stock outright. However, you’ll owe a lot of money if you’re at the wrong end of futures contract. The DJIA fluctuates daily based on a number of unexpected factors, such as geopolitical events, making futures a risky investment. If you’re interested in trading futures, your broker is required to give you information regarding the risks of futures and options trading.

If you have little exposure to the futures market, you may, at first, feel perplexed by Dow Futures. Each week, Zack’s e-newsletter will address topics such as retirement, savings, loans, mortgages, tax and investment strategies, and more. The Dow Futures provide an indication of where the stock market is headed before it opens.

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Investors seeking exposure to the DJIA can also purchase exchange-traded funds (ETFs) that track the index. Key considerations when choosing a broker are the ease of the trading platform, commission charges, customer service, features such as news and data feeds, and analytical tools such as charts. Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael.

For example, the March futures on the Standard & Poor’s 500 Index reflects the expected value of that index at the close of business on the third Friday in March. Although index futures are closely correlated to the underlying index, they are not identical. An investor in index futures does not receive (if long) or owe (if short) dividends on the stocks in the index, unlike an investor who buys the component stocks or an exchange-traded fund that tracks the index.

Definition and Example of Dow Futures

However, most days don’t offer market-moving economic reports or random non-financial events that have effect on the market. Futures markets aren’t burdened with the same short-selling regulations as stock markets. If you expect the DJIA to go up, buy a futures contract; if you expect the index to decline, sell one short. Take a position in the futures contract trading month you want to trade—the one with the closest expiration date will be the most heavily traded. In low-volatility markets with no significant economic reports, S&P futures may only vary from the previous close by a few points. In these cases, the cash market close will be more influenced by large institutions taking profits or adding to positions during normal trading hours.

For example, you can sell a corn future without having to store or deliver bushels of corn to the contract buyer. There are now two Dow futures contract sizes available, both of which trade on the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME). The E-mini, or mini-Dow, contract, as noted above, represents $5 per tick on the DJIA. The Micro E-mini is one-tenth the size of the E-mini, and represents 50 cents per point with a margin requirement of about $800, as of September 2023.

How Do Stock Index Futures Work?

If an institutional investor weighs in with a large buy or sell program in multiple stocks, the market impact can overwhelm whatever price movement the index futures indicate. Institutional traders do watch futures prices, of course, but the bigger the orders they have to execute, the less important the index futures’ direction signal becomes. A stock index futures contract binds two parties to an agreed value for the underlying index at a specified future date.