Index Future and Commodity Futures

28/07/2020 0 By indiafreenotes

Index Futures

Index futures are futures contracts where a trader can buy or sell a financial index today to be settled at a future date. Index futures are used to speculate on the direction of price movement for an index such as the S&P 500.

Investors and investment managers also use index futures to hedge their equity positions against losses.

Index futures, like all future contracts, give the trader or investor the power and the commitment to deliver the cash value based on an underlying index at a specified future date. Unless the contract is unwound before the expiration through an offsetting trade, the trader is obligated to deliver the cash value on the expiry.

An index tracks the price of an asset or group of assets. Index futures are derivatives meaning they are derived from an underlying asset the index. Traders use these products to exchange various instruments including equities, commodities, and currencies. For example, the S&P 500 index tracks the stock prices of 500 of the largest companies in the United States. An investor could buy or sell index futures on the S&P to speculate the appreciation or depreciation of the index.

Types of Index Futures

Some of the most popular index futures are based on equities. However, each product may use a different multiple for determining the price of the futures contract. As an example, the value of the S&P 500 futures contract is $250 times the S&P 500 index value. The E-mini S&P 500 futures contract has a value of 50 times the value of the index.

Index futures are also available for the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 along with E-mini Dow (YM) and E-mini NASDAQ 100 (NQ) contracts. Index futures are available for foreign markets including the German, Frankfurt Exchange traded (DAX) which is similar to the Dow Jones the SMI index in Europe, and the Hang Seng Index (HSI) in Hong Kong.

Margin and Index Futures

Futures contracts don’t require the trader or investor to put up the entire value of the contract when entering a trade. Instead, they only required the buyer to maintain a fraction of the contract amount in their account, called the initial margin.

Prices of index futures can fluctuate significantly until the contract expires. Therefore, traders must have enough money in their account to cover a potential loss, which is called the maintenance margin. Maintenance margin sets the minimum amount of funds an account must have to satisfy any future claims.

Both the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority, Inc. (FINRA) require a minimum of 25% of the total trade value as the minimum account balance. However, some brokerages will demand greater than this 25% margin. Also, as the value of the trade climbs before expiration the broker can demand additional funds be deposited to top-off the value of the account known as a margin call.

It’s important to note that index futures contracts are legally binding agreements between the buyer and seller. Futures differ from an option in that a futures contract is considered an obligation, while an option is considered a right that the holder may or may not exercise.

Profits and Loss from Index Futures

An index futures contract states that the holder agrees to purchase an index at a particular price on a specified future date. Index futures typically settled quarterly, and there are several annual contracts as well.

Equity index futures are cash settled meaning there’s no delivery of the underlying asset at the end of the contract. If on expiry, the price of the index is higher than the agreed-upon price in the contract, the buyer has made a profit, and the seller future writer has suffered a loss. Should the opposite be true, the buyer suffers a loss, and the seller makes a profit.

For example, if the Dow were to close at 16,000 at the end of September, the holder who bought a September future contact one year earlier at 15,760 would have a profit.

Profits are determined by the difference between the entry and exit prices of the contract. As with any speculative trade, there are risks that the market could move against the position. As mentioned earlier, the trading account must keep funds or margin on hand and could have a margin call demand to offset any risk of further losses. Also, the investor or trader must understand that many factors can drive market index prices including macroeconomic conditions such as growth in the economy and corporate earnings or disappointments.

Index Futures for Hedging

Portfolio managers will often buy equity index futures as a hedge against potential losses. If the manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures. Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline. In the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value offsetting the losses from the stocks.

The fund manager could hedge all of the downside risks of the portfolio, or only partially offset it. The downside of hedging is that hedging can reduce profits if the hedge isn’t required. For example, if in the above scenario, the portfolio manager shorts the index futures and the market rises, the index futures would decline in value. The losses from the hedge would offset gains in the portfolio as the stock market rises.

Commodity Futures

Commodities futures contracts are agreements to buy or sell a raw material at a specific date in the future at a particular price. The contract is for a set amount. It specifies when the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement instead of delivery.

The three main areas of commodities are food, energy, and metals. The most popular food futures are for meat, wheat, and sugar. Most energy futures are for oil and gasoline. Metals using futures include gold, silver, and copper.

Buyers of food, energy, and metal use futures contracts to fix the price of the commodity they are purchasing. That reduces their risk that prices will go up. Sellers of these commodities use futures to guarantee they will receive the agreed-upon price. They remove the risk of a price drop.

Prices of commodities change on a weekly or even daily basis. Contract prices change as well. That’s why the cost of meat, gasoline, and gold changes so often.

How They Work?

If the price of the underlying commodity goes up, the buyer of the futures contract makes money. He gets the product at the lower, agreed-upon price and can now sell it at today’s higher market price. If the price goes down, the futures seller makes money. He can buy the commodity at today’s lower market price and sell it to the futures buyer at the higher, agreed-upon price.

If commodities traders had to deliver the product, few people would do it. Instead, they can fulfill the contract by delivering proof that the product is in the warehouse. They can also pay the cash difference or provide another contract at the market price.

Commodities Exchanges

Future contracts are traded on a commodities futures exchange. These include the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. These are all now owned by the CME Group. The Commodities Futures Trading Commission regulates them. Buyers and sellers must register with the CFTC.

The role of the exchange is important in providing a safer trade.

The contracts go through the exchange’s clearing house. Technically, the clearinghouse buys and sells all contracts.

The exchanges make contracts easier to buy and sell by making them fungible. That means they are interchangeable. But they must be for the same commodity, quantity, and quality. They must also be for the same delivery month and location.

Fungibility allows the buyers to “offset” contracts. That’s when they buy and then subsequently sell the contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason, futures contracts are derivatives.