Helping to Explain Futures

by | Nov 26, 2016 | Asset Management

Index futures are futures “contracts” on a stock or financial index. A “futures contract” gives the owner the obligation to buy the underlying asset at some point in the future.

Unlike options (which give the holder the right — but not the obligation — to buy or sell an asset at a certain point in the future), futures embed the holder with the obligation to buy or sell the underlying assets in the future.

For example, the S&P 500 Index is one of the most widely traded index futures contracts in the United States; stock portfolio managers who want to hedge risk over a certain period of time often use S&P 500 futures. Dow Jones futures are another popular futures contract that trades. Technically, you can buy or sell futures contracts on ALL commodities, on the bond market (interest rate futures) and currencies (the direction of the dollar, the euro, yen, etc).

Many people refer to “futures” when talking about the stock market, or, in this case the S&P 500 Index. This is the most active futures contracts traded in the US. If a money manager wants to speculate on whether the S&P 500 will rise or fall in the future (the future could be three months or three hours), they can buy or sell futures.

This is where confusion can enter the picture. Remember in markets there is always a buyer and a seller. And a successful investment “plan” involves always “buying low, and selling high.” What financial markets allow folks to do is EITHER:
– buy now, and then sell later; or
– sell now, and then buy later.

So, yes, you can sell something without owning it first.

The first time people hear this it’s like trying to get them to understand “pig latin.” Selling first (called “shorting”), implies you will do the other side of the transaction (“buying back”) in the future, and hopefully buying back whatever you sold, at a lower price.

Remember if you did that correctly, you bought low and sold high. You just did in reverse order.

OK? Onward.

Managers do this (buy or sell futures contracts) instead of buying ALL 500 stocks in the S&P 500 Index. With commodities they buy and sell futures contracts instead of having to bring 500 tons of corn or oil to the Mercantile Exchange. Buying all 500 stocks would be really expensive and tie up a lot of money. Futures contracts are an easier way to buy or sell the whole market. So, managers and speculators can bet on the direction of the market (on a daily basis) by simply buying or selling futures contracts.

Futures trade in “contracts.” With commodities (suppose you are a grain farmer or a food company) you can “lock in” the price you want to sell your corn (or buy your corn) today with futures. If you think corn prices will fall in the future, you would sell futures. If you think wheat (or gold, or oil, or the stock market) will rise in the future, you would buy futures. Back in the 1980’s I traded futures and commodities (I don’t any more).

The futures contracts expire every three months, on the third Friday in March, June, September and December. At this time of year, the December expiration is the most actively traded contract because it expires in a few weeks. The closest expiration also becomes the most sensitive to changes in price because daily news will drive the direction of the price.

So if something crazy happens (around the world) over the weekend, we can see S&P futures trading lower on Sunday night, ahead of the stock market opening on Monday morning. Likewise if something positive happens, or if other markets around the globe are up Sunday night, we could see futures trading up Sunday night heading into the open on Monday. Futures end trading before the actual markets open at 9:30 Eastern time Mon-Fri.

The knuckleheads on TV use the S&P futures (and Dow Jones futures) to give them “an indication” of how the stock market MAY open that day. But remember, when you sell a futures contract first (in anticipation of a future drop), at some point you have to BUY it back. So, sometimes, futures may indicate a higher Wall Street opening, but then the market is down. Futures trading does not “always” provide an accurate indicator of how stocks will trade that day. Despite what those ding dongs on TV sometimes say.

I often ask clients who ask about futures trading if they have ever watched the Eddie Murphy/Dan Ackroyd movie “Trading Places.”  The trading scene near the end of the movie used to be a pretty accurate depiction of (the concept behind) how trades work. However most trading is now done on computers instead of trading in the actual “trading pits.”

The Chicago Mercantile Exchange (CMEGroup) establishes limits for trading futures. These limits are designed to line up with circuit breaker levels set by the New York Stock Exchange. The 7%, 13%, and 20% price limits are applied to the futures and are effective from 8:30 a.m. CT – 3:00 p.m. CT (these are NYSE market hours), Mondays through Fridays.

The 5% up-and-down limits are effective overnight – from 5:00 p.m. – 8:30 a.m. CT. Sundays through Fridays; and 3:00 p.m. – 4:00 p.m. CT, Mondays through Fridays.

In the recent example of the November 8, 2016 Presidential Election, Dow Jones futures at one point in the evening traded “limit down” 800 points.  This 800 point drop on Dow Jones futures was the maximum amount futures could trade down in that session.  Futures could not trade any further lower until the following morning.  Futures could trade higher — but not lower — once reaching the limit down.

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