What are index futures and how do they work?

Index futures contracts are a type of derivative whereby parties involved enter into a commitment to either pay or receive the value of an underlying index at a predetermined future date. It is common for index futures to be based on equities, such as the NASDAQ 100, FTSE 100, EURO STOXX 50, AEX and S&P 500 index.

Since it is not possible to own an index, this type of futures contract enables investors to gain exposure to the performance of an index instead of having to own all of the assets represented in the index.

Buyers (long position) and sellers (short position) of index futures generally have opposing beliefs about the price of the underlying index at the maturity date. Buyers will realise a gross profit if the index’s value has increased at maturity and a gross loss if it has decreased. On the other hand, a seller will realise a gross profit if the value of the underlying index has decreased at maturity and a gross loss if it has increase.

How do index futures work?

In contrast to other financial products such as stocks, with futures, you do not pay the full cash amount upfront or own the underlying asset. Instead, you deposit initial margin to enter the futures position. The amount of margin required is a percentage of the contract value. At ESKIMO, you can find the risk category of a product next to its name, which represents how much margin will need to be deposited to enter the contract.

To find the value of a futures contract, you multiply the spot price of the index by its contract size. In contrast to commodity futures, for example, where the contract size represents a certain amount of a deliverable commodity, such as 1,000 barrels of oil, the contract size of an index future is set by a multiplier.

For example, the multiplier for an S&P 500 futures contract is $250 per index point. If the S&P 500 trades at 3,370, then the contract’s value would be $842,500 ($250 x 3,370 = $842,500). On the other hand, E-mini S&P 500 contracts represent a fifth of the value compared to a regular S&P 500 index future. In this case, if the S&P 500 trades at 3,370, then the contract’s value would be $168,500 ($50 x 3,370 = $168,500).

Since only a percentage of the contract’s value needs to be put up initially, index futures are highly leveraged financial instruments. This means that slight price movements can have a large impact. When the margin requirement is higher, an investor typically needs to deposit more margin to enter the future position. This, in turn, results in lower leverage.

Futures contracts have a minimum price increment to which a particular contract can fluctuate, known as the tick size. This is determined in the specifications of the contract set by the exchange. Tick value, on the other hand, is the actual monetary amount that is gained or lost per contract per tick move and is equal to the tick size multiplied by the contract size.

How and when are index futures settled?

A unique feature of futures is that they are settled daily. At the end of each trading day, the closing market price is determined by the exchange that the future trades on. This is known as the daily mark-to-market (MTM) price and it is the same for everyone. There are daily mark-to-market settlements until the expiry of the contract or the position is closed out.

The daily cash settlement is the difference between the closing price of t-1 and t. Depending on the result, the contract holder’s account is either debited or credited. For example, if at the daily settlement there is an increase in the contract’s value, this will result in a credit to the long position holder’s account and a debit to the short position holder’s account.

With ESKIMO, if a debit causes the short position holder’s account balance to fall below the maintenance margin, he or she will receive a margin call and will have to deposit more funds into the account. If the investor does not resolve the deficit before the deadline given in the margin call, ESKIMO will intervene and close positions on the investor’s behalf to cover it. When ESKIMO has to intervene, there are additional fees involved.

At expiry, other types of futures, such as commodity futures, can be either cash settled or physically settled by delivering the underlying asset. Index futures are only cash settled.

Where can I find information?

Since futures are traded on an exchange, information and specifications about the contract can be found on the exchange’s website. This includes information such as the contract’s size, underlying index, maturity date and trading hours. Other information about the characteristics and risks of the product can be found in its Key Information Document (KID). You can find a product’s KID within the ESKIMO platform when you select a futures’ name and then select ‘Documents’.

How can I invest in index futures with ESKIMO?

At ESKIMO, you can trade in futures on a number of affiliated derivatives exchanges. You can find all of the futures contracts we offer when you log into your account and select futures under the products tab.

ESKIMO charges connection fees, transaction costs, and settlement costs for trading in futures. You only pay settlement costs at the final settlement upon expiration, not before. It is possible that the exchange that the future trades on also charges a commission. These fees can also be found in our Fee Schedule.

What are the risks and rewards?

Trading on the futures markets can result in high rewards, but it also comes with high risk. You can end up losing more than your initial investment. Since the underlying index of an index future can theoretically increase without limits, with a long position, the maximum profit of an index future is also unlimited. On the other hand, if you are in a short position, the maximum loss is also unlimited. It is recommended to only enter into obligations that you can meet with money that you do not need in the short term.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.