Understanding Index Futures and How They Work

New to index futures? This brief introduction will outline the essential things you need to know about these financial investment vehicles. Let’s consider the term “index future” itself to outline what we are talking about. An index refers to a statistical instrument to measure change in a defined market or economy. In an index future, the index normally refers to a stock index, such as the Dow Jones Industrial Average (DJIA) or  the NASDAQ.

 

What is a Stock Index?

A stock index is a composite of various stock prices that is then converted into a  numerical scale. The calculation of a stock index can be rather complex, but it suffices to say that it measures the change in a certain sector, industry, or portfolio of companies over time. The DJIA, for example, measures the world’s largest blue chips, while the NASDAQ monitors the technology industry.

Developments within a single company rarely affect indexes. For example, a scandal or hit product, or other important event, will normally not be enough to cause a major shift in an index. An individual stock price could rise or fall very quickly in the wake of an important event, but the index itself will likely move by only a few points. Some investors prefer investing in indexes because they find it easier to predict and analyze general trends, rather than individual stocks.

What are Futures?

This brings us to the second word in our term, “futures”. A future is a contract that obligates a buyer to buy a certain asset at a specific price on a specific date. It also obligates the seller to sell at the agreed upon terms. Investors usually use futures to “bet” on future developments or trends within a market or regarding a specific asset. Investors also use futures to hedge against risks.

The futures market is highly speculative. In many ways, investing in futures is like gambling. So many events and developments can occur unexpectedly that there is always a risk that you could lose money, no matter how much research you conduct and how well prepared you are. So when investing in futures, make sure you exercise caution.

Making Money With Index Futures

Risks and Rewards

Where there are risks, however there is also a potential to produce substantial profits. With futures, you are trying to determine the direction that indexes will go in. Is the DJIA set to secure major gains in the near future? Could a technology bubble be building that will wipe out the value of the NASDAQ? If you can correctly predict these sorts of events, you can make a lot of money through  futures.

Going Long or Going Short

Futures are two way contracts, and one party always goes long while the other party always goes short. The party going long will be the buyer, while the party going short will be the seller. As an investor, you can invest long by buying a contract, or you can invest short by short-selling a contract. If you believe that indexes are currently being undervalued, you will invest long. If you believe indexes are being overvalued, you will sell short.

Still a bit confused? How about we use an example to clarify things. Let’s say you believe that the DJIA will rise to 17,000 points in February. However, a trading firm is currently selling a DJIA index future for 16,500 points. If you buy the future and turn out to be correct, you will earn money as the index rises above 16,500 points. On the other hand, if you turn out to be incorrect, and the index drops below 16,500 points, the trading firm will profit.

As you can see, there is a lot of potential for making money with futures. If you are able to predict major developments or trends in markets, you can make serious money from futures trading. On the other hand, if your predictions turn out to be incorrect, you could end up losing a lot of money. This is true of any high-risk, high-reward investment, but it is a point you should consider closely when investing in index futures.