What Are Dow Futures and How Do They Work?
A Basic Introduction to Dow Futures Contracts
As you explore the world of investing and learn about different types of securities, you will probably come across trade indexes such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's (S&P) 500. In these indexes, you'll find commodities trading, in which you can trade commodities futures contracts on the index instead of buying into securities.
If you have little exposure to the futures market it might seem confusing, especially if you hear about Dow Futures and the influence they would have on the direction of the stock market. If you're perplexed by Dow Futures, here are some of the basics.
What Are Dow Futures?
Futures are commodity trades, with set prices and dates for delivery in the future. A basic approach to understanding this is to think of a farmer and a grocer. The grocer knows that the farmer will have a crop of soybeans to be harvested soon, so she offers to buy 100 bushels of soybeans in January for $900.
If the farmer agrees, the contract has been made, and each wait for January. No matter the price of soybeans in January, the price set is what the grocer pays.
A futures contract is a legally binding agreement between two parties (which can be individuals or institutions) in which they agree to exchange money or assets based on the predicted prices of an underlying index.
Futures should not be confused with futures options. Options are derivatives of the futures market, which have a market and exchange of their own. Options are purchased to give the holder the right but not the obligation to exercise the terms of the commodities deal. In a futures contract, both parties have an obligation to perform their part of the deal.
Where Do Dow Futures Trade?
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.
The exchange exists to keep trading fair and eliminate risk—such as one party not delivering on the contract. By having all of the futures contracts cleared through the exchange, this risk is eliminated because the exchange serves to guarantee every position.
When Can You Trade?
Dow Futures start trading each day on the Chicago Board of Trade (CBOT) at 7:20 a.m. Central Time (8:20 a.m. Eastern Time), which is an hour and ten minutes before the stock market opens, allowing trading to take place so reporters and professionals can get an idea of market sentiment (the attitude of investors on prices and market potential).
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 raise 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. This creates the possibility of stocks also falling once the opening bell rings.
Buying Futures With Leverage
Dow Futures have built-in leverage, meaning that traders can use significantly less money to trade futures while receiving exponential returns or losses. This can allow traders to make substantially more money on price fluctuations in the market than they could by simply buying a stock outright.
The Dow Jones futures use a multiplier of 10 (often called 10 to one leverage or 1,000% leverage). 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.
As a result, a trader who believed the market was going to rally could simply acquire Dow Futures with a smaller amount of money and make a huge profit as a result of the leverage factor.
If the market were to return to a level of 14,000, for instance, from the current 8,000, each Dow Futures contract would gain $60,000 in value (6,000 point rise x 10 leverage factor = $60,000). It's worth noting that the opposite can also easily happen. If the market were to fall, the Dow Futures trader could lose huge sums of money.