Equity Index Futures & Options: Overview and Uses
Jan 9, 2018
Of the six main futures categories, equity index futures are probably one of the best known to the average trader.
Equity indexes represent the value of a particular slice of the stock market.
While indexes themselves cannot be bought or sold, financial products that track their value are accessible to investors and traders. The SPY is a widely utilized exchange-traded fund (ETF) that tracks the S&P 500.
Equity index futures are another avenue for traders and investors to access exposure to stock market indexes. These products were first introduced in 1982.
In the United States, equity index futures are available on the S&P 500, the Nasdaq 100, the Dow Jones Industrial Average, and the Russell 2000 (among others). Equity index futures are also available on foreign stock markets (i.e. Germany, Japan, Hong Kong, United Kingdom, etc...).
Because the "standard" futures contracts on equity indexes can represent a large notional value (and therefore require large sums of capital), the E-mini line of futures was first introduced in 1997.
The E-mini series was designed to increase accessibility to equity index futures through a reduced multiplier, which effectively decreases the amount of capital needed to trade them. For example, the E-mini S&P 500 (/ES) is one-fifth the size of a standard S&P 500 futures contract (/SP).
Mechanically, this is achieved through a reduction in the contract multiplier. The notional value of an index futures contract is the spot value times the multiplier. In the case of the standard S&P 500 contract (/SP) that multiplier is $250, whereas the E-mini S&P 500 contract (/ES) multiplier is only $50.
An index futures contract states that the holder agrees to purchase an index at a particular price on a specified date in the future.
If on that future date the price of the index is higher than the agreed-upon price, the buyer has made a profit, and the seller has made a loss. If the price of the index is lower, the buyer has made a loss, and the seller has made a profit.
Unlike some other futures products, equity index futures do not call for the delivery of the actual stocks associated with the index. Instead, they are daily settled on a "mark-to-market" basis. That means participants pay losses or collect profits daily in cash.
As mentioned previously, the contract multiplier (aka "contract size") is an important concept to understand when trading equity index futures. Assuming that the S&P 500 is approximately 2,560, you can see in the example below how the notional values of the standard S&P 500 futures contract and the E-mini S&P 500 contract differ:
S&P 500 (/SP) notional value: 2,560 x $250 = $640,000
E-mini S&P 500 (/ES) notional value: 2,560 x $50 = $128,000
Equity index futures also have a minimum price fluctuation, known as a "tick." The tick value is the minimum amount that an equity index future can move up or down. Both the multiplier and the tick value vary by product.
The image below depicts the contract multiplier and tick size for some of the best-known E-mini equity index futures products:
Equity index futures are cash settled and consequently, there are two important terms associated with this process that traders need to understand: "daily settlement" and "final settlement."
For most equity index products, the daily settlement price is calculated using a volume-weighted average price (VWAP) based on the last 30 seconds of the trading day. Market participants use daily settlement information to manage daily profit and loss, as well as to adjust margin levels with their clearing firms.
Final settlement occurs at the conclusion of the contract's life via the Special Opening Quotation (SOQ). The SOQ is determined by the index provider and is calculated using the actual opening prices for each of the underlying constituent stocks.
Due to their wide acceptance and deep liquidity, equity index futures are used by a wide variety of market participants.
Like many futures products, the range of strategies typically deployed in equity indexes includes:
Speculation in equity index futures isn't much different than any other major asset. Bulls purchase equity index futures such as the E-mini S&P 500 when they think stock prices are set to increase. A trader that is bearish on stock prices might decide to short the E-mini S&P 500.
On the other hand, some market participants use equity index futures to hedge risk in their portfolios. For example, a trader holding a significant short gamma or vega position may decide to short the E-mini S&P 500 to protect his/her portfolio in the event of an unexpected correction.
Spreads also play an important role in stock index futures. A spread is the simultaneous purchase and sale of two futures contracts. Such a position is designed to profit from changes in the relative value of two contracts, as opposed to outright speculation.
Because index spreads involve both a long and short position they are generally viewed as less risky than an outright position in a single contract. Having said that, futures spreads do possess risk, and traders need to ensure such positions match their risk profile and outlook.
Futures spreads can be deployed in different maturities of the same underlying future, or in two different underlying futures. The former is often called an “intra-market” calendar spread, while the latter is known as an “inter-market” spread.
Practically, an intra-market spread might be executed by purchasing a near-term maturity future in /ES, in favor of selling a longer-term maturity in /ES. Alternatively, an example of an “inter-market” spread might be to purchase the E-mini Nasdaq versus selling the E-mini S&P 500.
It’s important to highlight that inter-market equity index futures spreads are often executed in ratio fashion. This is done to help balance delta exposure across both legs of the trade.
In the near future, we’ll be following up with additional blog posts dedicated to equity index futures. These posts will include sample trades and more details on the practical application of the spread ratio.
Traders seeking to learn more about equity index futures in the interim should find the links below helpful:
If you have any questions related to equity index futures we hope you’ll leave a message in the space below, or reach out directly at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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