How Index Futures Tell the (Near) Future
By Peter Di Teresa
Dear Professor,
Every morning I watch the financial news before the stock market opens. Every day, the show lists futures numbers for the Dow, Nasdaq, and S&P 500. What is a future? Are futures good predictors of the market's direction on a given day?
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William S.
These investments may be called futures, but they provide only short-term predictions--and not necessarily reliable ones. Here's what futures do and how they can indicate market moves.
What Index Futures Do
The futures William mentions are known as stock-index futures. That means they are futures contracts for specific indexes, such as the Dow Jones Industrial Average, Nasdaq, and S&P 500. These futures and others for commodities such as beef or coffee, currencies, and interest rates are traded at the Chicago Board of Trade and Chicago Mercantile Exchange.
Whether futures are for pork bellies or the S&P 500, they work in pretty much the same way. A future is a contract to deliver something at a specific date and for a set price. The quantity, delivery date, and location are all standard in these contracts; the only variable is the price.
Investors can use index futures to hedge against risk, or to place a bet on an index's strength without having to actually buy the stocks. Let's say you own a portfolio full of S&P 500 stocks and you're convinced that a market downturn is imminent, but you don't want to sell your holdings and incur taxable gains. You could sell S&P 500 futures instead.
Index futures contracts move in step with the underlying indexes, so if you're right and the index falls, you can buy back the contract for less than you were paid for it in the first place--you make a profit. Even though the stocks you own have gone down, you've tempered that loss with a profit from your futures. (The Chicago Mercantile Exchange's Web site has a more detailed example of this and other ways to use futures.)
How Index Futures Foretell the Market's Moves
In the above example, you were able to hedge your stock investments because index futures move up and down in sync with the underlying index. But they don't necessarily move perfectly in sync, and that's what some investors are looking for.
Discrepancies between the value of the futures contract and the index can occur during the trading day. Such discrepancies don't last long, ending in a matter of minutes. The contract and the index can be out of line at the end of the trading day, too. If there's a significant difference between the values of the contract and of the index when the market opens, the stocks in the index may go up. That's because investors trade between contracts and stocks to take advantage of such discrepancies, selling the more expensive futures and buying the cheaper stocks.
If you follow index futures, you won't be looking terribly deeply into the womb of time, though. The futures and index are usually back in line within minutes. The gains are also incremental, often just fractions of a percent.
Complexity Weakens the Predictive Power
Not only are the opportunities short-lived and the gains small, but also index futures aren't very reliable predictors of short-term index moves. That's because the cost of taking advantage of a discrepancy may be prohibitive. Futures contracts carry premiums, or fees for creating them, along with brokerage commissions; stock purchases also carry commissions. These expenses can vary from investor to investor, making efforts to exploit differences between index and contract values too costly to bother with for some investors.
This article originally ran on August 21, 2000. |
