What Are Stock Index Futures and How Do You Buy Them?
Investing in stock market futures offers both risk and reward
Stock index futures are the crystal ball of the financial markets—bets on the direction of the equities market, and tracking key stock market indices to get the job done.
The history of stock futures, in general, dates back to the 1840’s, when regional farmers met in Chicago to sell wheat to dealers for cold, hard cash—a practice that was dubbed as “spot” pricing. That scenario evolved to include trades for future bushels of wheat, enabling the seller to know how much he as getting for his wheat down the road, and the buyer knew costs he’d be paying for his wheat.
A century-and-a-half later, that “evolution of futures” led to the creation of the stock index futures contract, which started trading on the Chicago Mercantile Exchange in 1997, and still offers robust trading today for buyers and sellers with a long-term view of stock-related financial investments.
Defining Stock Index Futures
In a word, stock index futures are legal agreements to either purchase or sell stocks on a future date, and at a specific price. The practice enables investors to speculate on future stock price performance, giving them more leverage along with access to 24/7 securities trading in highly regulated markets, without actually owning the stock market index that the futures contract covers.
By far their biggest attraction (aside from providing much-needed portfolio diversification) is the potential to cash in on a big investment return with little money down. But that’s a scenario that can work against stock index futures investors who bet too much on future market outcomes, wind up highly leveraged, and lose their entire investments when market conditions go against them.
By and large, stock index futures are complicated financial instruments and should be avoided by Main Street investors. If, however, you’re curious about how they’re traded and feel that you’ve got the financial chops to handle a futures contract, here’s the deal.
What to Know When Investing in Stock Index Futures
Keep these data points in mind when investing in stock index futures:
Types of Stock Index Futures: By and large, there are four widely-used stock index futures trading contracts available to U.S. investors, all based on the major U.S. stock market indices (including the Dow Jones Industrial Average, the NASDAQ 100, the Russell 2000 Index, and the Standard & Poor’s 500 Index.)
Trading Matters: Typically, stock index futures are traded with the help of a futures broker, who facilitates the trade on both buy and sell orders. Just like traditional stock market securities trading, buy positions allow investors to profit from a rising stock market while a sell order enables investors to benefit from a declining stock market.
Costs to Trade: When buying stock index futures contracts linked to the above indices, you’re paying much less than the listed price for the actual stock market index tracked by the futures contract. For example, a $100 per-share investment for 100 shares of the S&P 500 Index would cost $10,000. By purchasing a single S&P 500 futures contract (or 100 shares of the index), however, the futures investor pays a significantly lesser amount.
Cash Caveats: There is one important distinction when investing in stock index futures. To participate, futures investors are required to keep cash in what’s called a “margin” account at a brokerage firm. Margin accounts are required to cover steep losses on a futures trade, an occurrence that’s known on Wall Street as a margin call. Always make sure to understand an investment company’s margin requirements before signing up to trade futures.
Recognize the Risk: The downside of that index futures investment is the high level of risk inherent in buying and selling such contracts. The National Futures Association does a good job of detailing the intricacies of leverage and risk linked to stock index futures (find it at NFAFutures.org.) It’s also a good place to vet any potential brokers you’re considering helping you invest in stock index futures. In that process, you’ll want to check any fees linked to futures trading, any complaints lodged against the broker, and its track record in generating clean, fair stock index future trades.
Consider ETF’s: Not sure you want to go it alone? Consider stock index exchange-traded funds, which offer access to stock futures, but without the relatively higher level of risk of standalone stock market index vehicles. For example, the benchmark SPDR S&P 500 Fund (SPY) and the iShares Russell 2000 Index ETF (IWM) both offer access to stock index futures.
Talk to an Expert
The takeaway? If you’re going to invest in stock index futures, consult with an investment advisor or other experienced financial professional before inking any deals.
You’ll benefit from a seasoned, objective investment industry source who can properly explain the risks and rewards of stock index futures investing—before you put your portfolio proceeds on the line, and potentially in harm’s way.