A futures contract represents a legally binding agreement between two parties. In the contract, one party agrees to pay the other the difference in price from when they entered the contract until the date the contract expires. Futures trade on exchanges and allow traders to lock in the prices of underlying assets named in the contracts. Both parties are aware of the expiration date and prices of these contracts, which are generally established upfront.
Each contract carries a multiplier that inflates its value, adding leverage to the position. Contracts can be traded on the long or short side without restrictions or uptick rules. There are many different futures contracts, including those that deal with equities, commodities, currencies, and indexes. In this article, we explain the basics of index futures contracts and what they represent.
Key Takeaways
- An index futures contract is a legally binding agreement between a buyer and a seller, and it tracks the prices of stocks in the underlying index.
- It allows traders to buy or sell a contract on a financial index and settle it at a future date.
- The S&P 500, Dow, and Nasdaq futures contracts trade on the CME Globex system and are called E-mini contracts.
- The contract multiplier determines the dollar value of each point of price movement.
Index Futures Contracts
Like a regular futures contract, an index futures contract is a legally binding agreement between a buyer and a seller. It allows traders to buy or sell a contract on a financial index and settle it at a future date. An index futures contract provides a way to speculate on price movements for indexes like the Nasdaq 100.
As futures contracts track the price of the underlying asset, index futures track the prices of stocks in the underlying index. Nasdaq 100 contracts track the stock prices of the 100 largest companies listed on the Nasdaq stock exchange. Similarly, Dow and futures contracts track the prices of their respective stocks. All of these index futures trade on exchanges.
The index futures contract mirrors the underlying cash index and acts as a precursor for price action on the stock exchange where the index is used. Index futures contracts trade continuously throughout the market week, except for brief breaks for settlement and maintenance.
E-Mini Contracts
The S&P 500, Dow, and Nasdaq 100 futures contracts trade on the CME Globex system and are called E-mini contracts. Contracts are updated four times per year, with expiration taking place during the third month of each quarter.
E-mini futures contracts trade from Sunday evening through Friday afternoon, offering traders nearly continuous market access during the business week. Liquidity tends to dry up between the U.S. equity market close and the opening of the European stock exchanges in the early morning hours. Spreads and volatility can widen during these periods, adding significant transaction costs to new positions.
E-mini futures contracts trade from Sunday evening through Friday afternoon in the United States.
What happens if the E-mini Nasdaq 100 futures contract trades higher before the opening of U.S. stock markets? It means the Nasdaq 100 cash index will trade higher following the opening bell. Contracts track U.S. indexes closely during regular stock market trading hours. However, futures contracts will be priced higher or lower because they represent expected future prices rather than current prices.
Contracts denote approximate valuations for the next trading day when U.S. markets are closed. Prices are based on perceptions about overnight events and economic data and movements in related financial markets. Forex markets—which also trade nearly 24 hours per day—can make a substantial impact on futures prices when U.S. stock exchanges are closed. Large movements up or down by foreign stock exchanges also play a significant role in determining overnight futures prices.
Contract Multipliers
The contract multiplier determines the dollar value of each point of price movement. The E-mini Dow multiplier is 5, meaning each Dow point is worth $5 per contract. The E-mini Nasdaq multiplier is 20, worth $20 per point, while the E-mini S&P 500 carries a 50 multiplier that's worth $50 per point. If the Dow falls 100 points, then the buyer will lose about $500 while a short seller will gain around $500.
It is essential to realize that a higher contract multiple does not necessarily imply more risk because indexes have different values. For example, the Dow closed at 25,383.11 on May 29. At the same time, the Nasdaq 100 ended at 9,555.52, while the S&P 500 closed at 3,044.31. Suppose an amazing coincidence took place, and all three indexes went up precisely 1%. Then, an E-mini Dow contract would go up by about $1,269, an E-mini Nasdaq 100 contract would rise by around $1,911, and an E-mini S&P 500 contract would increase in value by approximately $1,522. The volatility of the underlying index also has an impact on risk.
Index futures contracts are marked to market, meaning the change in value to the contract buyer is shown in the brokerage account at the end of each daily settlement until expiration. Suppose the Dow drops 100 points in a single trading day. Then, around $500 will be taken out of the contract buyer's account and placed into the short seller's account at settlement.
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