Stock Index Futures, their Application and their link to CFDs


Q.: What's the difference between stocks and futures?

A: Trading stock involves bringing people with extra capital together with entrepreneurs to develop a business. They facilitate the transfer of ownership of the corporations. Property rights change hands. Whereas trading futures brings people together to transfer the price risk associated with the ownership of some instrument like a commodity, like wheat, or a service, like an interest rate. No property rights to a physical commodity change hands at the time the futures contract is entered into. In many ways, this makes trading futures vs. stocks much simpler in terms of taxes, execution, short selling and analysis.

Q.: What are stock futures?

A: Buying a share on the futures markets consists of a buyer agreeing to buy or take delivery of the share at a future date (unlike CFDs where delivery of the stock never takes place) but paying the current market price. Most futures will be sold before this settlement date, meaning that the underlying share or instrument never really changes hands. As with contracts for difference stock futures are also traded on margin so again there is the potential of making big gains but equally big losses. These type of equity derivatives are more commonly associated with commodities or fixed income markets where traders or institutions have traditionally tried to hedge against adverse price movements and stock futures can be found through a number of exchanges globally. As with other derivative contracts a multitude of trading strategies are possible - such as combining long and short stock futures with a holding in the underlying shares or using them in conjunction with options which confers on the trader the right, but not the obligation, to buy and sell share futures when they reach a certain price (known as the strike price). However, this is a complex area which has defeated even Nobel-winning economists so you may want to start with the simplest of options strategies available!

 

Q.: I've read that trading futures is better than equities for a small-time starting trader because far less capital is at risk...


This always assuming sensible stop loss orders, and the potential gains are massively geared.

A: Trading futures straight out is committing suicide, and whoever told you that must be given a smack. Hefty margins and large contract values usually mean that one single contract will cost you all your money on margin - and the worst is that it can all be gone with one single intraday.

Q.: What are stock index futures?

A: The principle of trading in stock index futures is the same as any other futures market, except that the trader is effectively buying and selling a set of numbers, and no physical delivery of an underlying asset is possible. This means that positions are settled in cash at the expiration of the contract at either a profit or loss, although the vast majority of index futures contracts are either settled prior to expiry, or ‘rolled over’ to a later expiry date.

The value of a stock index contracts is fixed by the exchange upon which the index is traded. One of the more popular (and most expensive) indices to trade is the S&P 500, where each point has a fixed value of $250, and where quick profits (and losses) can be made. So, say the index is valued at 1,000 points when it is bought, one S&P futures contract will be worth $250,000. If one contract is bought on a 10% margin, the trader must put up $25,000 to initiate the position. If the index swings by a relatively brisk twenty points during the rest of the day, the trader has the potential to gain, or to lose, $5,000 in one fell swoop ($250 multiplied by 20 points).

Clearly this is not for the faint hearted or light of pocket and because of this some exchanges have developed e-mini contracts where the index would otherwise would be prohibitively expensive or too risky for smaller traders. The S&P 500 e-mini contract is worth $12.50 per quarter of one index point, meaning that one contract is worth $50,000 if the index is valued at 1,000 points, so a 20 point swing represents a loss or gain of $1,000. It is worth mentioning that not all indices are as expensive to trade as the S&P 500 or Nasdaq 100. For instance, FTSE 100 index futures, traded on the London International Financial Futures Exchange (LIFFE) are worth £10 ($18) per index point. Note also that CFD index futures allow you to trade stock index contracts with smaller stakes.

Stock index futures like most other derivative instruments have their origin in the United States and have been on the investment map since their introduction in the early 1980s although they have only recently appeared on the radar of the smaller investor. Originally developed as a hedging instrument for institutional traders to provide protection against a price reversal of the stocks in the manager’s portfolio they can now be used as tools of speculation among private individuals day trading. They are also used as a basis for pricing CFD index futures.

Futures provide a similar exposure to CFDs, but the minimum trade size is normally much bigger.

Q.: How do CFDs compare to futures?

A: CFDs are derivatives, just like options and futures. However, a futures contract and a CFD are very much different.

A futures contract is traded on a Futures Exchange; futures are standardized contracts that specify the position size and expiry date - when you buy or sell a Futures contract you could be buying or selling from anyone in the world. You do not know who you are buying from or selling to, the person/organisation on the other side of your trade doesn't know who he or she (or it) is selling to or buying from.

A CFD is traded with a CFD provider/supplier (I am going to call them suppliers here - they supply both bids and offers, they will both buy and sell from/to you); when you buy or sell a CFD you can ONLY trade with the supplier - the supplier knows who you are, you know who the supplier is. CFDs in this sense are customized derivatives that do not have a standardized form.

Single stock futures have an expiry date and thus their pricing includes a forward premium of interest and a discounted dividend which can be confusing. In this CFDs are often simpler to comprehend as they trade at the spot price (with a small commission on top). And for any average retail customer I would gravitate towards saying that CFDs are a better product than a comparable future. But there is a risk due to the fact that futures are standard, transferable instruments while CFDs are over-the-counter, issued by the broker which means that your choice of provider becomes more important as CFDs are settled directly with the broker as opposed to a clearing house. Generally, the larger the broker the better their systems and their products, especially as regards price continuity.


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