It becomes worth less because the company used profits to pay dividends. Investors make predictions about the direction of the Dow Jones Industrial Average. If they think the 30 stocks in that average will move in a certain direction, they can issue a futures contract, which is a promise to buy or sell the DOW stocks at a future date. Dow Futures are financial futures which allow an investor to hedge with or speculate on the future value of various components of the Dow Jones Industrial Average market index. The futures instruments are derived from the Dow Jones Industrial Average as E-mini Dow Futures.
If you’ve ever listened to an early morning financial news broadcast, you’ve heard a reference to “futures” and how they affect the stock market before it opens. Investors follow the futures because it provides an indication of where stocks are headed at the opening bell. One of the most widely followed futures is the Dow Futures, whose underlying value is based on the Dow Jones Industrial Average, an index of 30 major U.S. companies.
The Federal Reserve releases minutes of the open-market committee eight times annually during normal cash market hours. This is typically followed by a large increase in volatility and a strong move in either direction, depending on the statement issued. On these days, pre-market activity may have little influence on the cash market close.
- By having all of the futures contracts cleared through the exchange, this risk is eliminated because the exchange serves to guarantee every position.
- If instead of rising, the DJIA fell from 12,000 to 11,984, the futures buyer would settle the transaction by paying the futures seller $160.
- Similarly, major reports that indicate a strong change in conditions will usually cause a reversal in the futures market and a like move in the cash market.
- Before getting into the Dow Futures, it is important to understand the definition of a future.
- Buyers may want to hold off when index futures predict a lower opening, too.
Suppose good news comes out abroad overnight, such as a central bank lowers interest rates or a country reports stronger-than-expected growth in GDP. The local equity markets will probably rise, and investors may anticipate a stronger U.S. market, too. And with index arbitrageurs on the sidelines until the U.S. stock market opens, nobody will counteract the buying pressure even if the futures price exceeds fair value. Futures traders have the advantage of a nearly 24-hour-long trading day and the ability to react quickly to news that happens when cash market participants’ hands are tied.
An index tracks and measures the price of a collection of assets, such as a group of stocks. Index futures are derivative financial contracts, meaning they derive their value from an underlying asset, in this case, the index. Index futures can be bought and sold and their value changes with the value of the index. A trader can buy an E-mini Dow contract for about $5,500—and that futures contract is worth $5 for every point on the DJIA. So if you buy when the index itself is at 29,000, and sell when it hits 30,000, you’ve made $5,000 on the trade, nearly doubling your money. Dow Futures have built-in leverage, meaning that traders can use significantly less money to trade futures while receiving exponential returns or losses.
Futures Margin Requirements
This can allow traders to make substantially more money on price fluctuations in the market than they could by simply buying a stock outright. However, you’ll owe a lot of money if you’re at the wrong end of futures contract. The DJIA fluctuates daily based on a number of unexpected factors, such as geopolitical events, making futures a risky investment. If you’re interested in trading futures, your broker is required to give you information regarding the risks of futures and options trading.
The futures buyer receives a deposit in his brokerage account of $650 from the seller. If instead of rising, the DJIA fell from 12,000 to 11,984, the futures buyer would settle the transaction by paying the futures seller $160. In addition to the front month, Dow futures are listed quarterly, with expirations in March, June, September, and December. These contracts are cash-settled, meaning that delivery is made in the equivalent value of the index rather than in the stocks that make up the index itself. When you see on a morning financial program that the DOW futures are up, you may be tempted to assume that means the market opening will be up as well. But the term “futures” hints at its underlying meaning — it’s an estimate of a stock’s future worth based on a best-guess prediction of the stock’s movement.
The Dow Jones consists of 30 companies while the S&P 500 consists of 500 companies, so there is more diversification in the S&P 500. In regards to performance, depending on the time frame evaluated, one will perform better than the other. When you open a position, the broker will set aside the required initial margin amount in your account. To hold the position, you must maintain sufficient capital in your account to cover the maintenance margin. It is also possible to partially close out of a position if you have more than one contract—for example, selling three of five contracts originally bought, leaving a position of two contracts open.
How Do Stock Index Futures Work?
Still, Dow index futures are a popular tool for getting broad-based exposure to U.S. equity or hedging such positions. Index futures trade on margin, which is a deposit held with the broker before a futures position can be opened. For example, an investor who buys $100,000 worth of futures must put up a percentage of the principal amount and not the entire $100,000. Banks and brokerages calculate the cost of borrowing money if you actually had to buy all of the DOW stocks.
For example, you can sell a corn future without having to store or deliver bushels of corn to the contract buyer. There are now two Dow futures contract sizes available, both of which trade on the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME). The E-mini, or mini-Dow, contract, as noted above, represents $5 per tick on the DJIA. The Micro E-mini is one-tenth the size of the E-mini, and represents 50 cents per point with a margin requirement of about $800, as of September 2023.
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A futures contract is a legally binding agreement between two parties (which can be individuals or institutions) in which they agree to exchange money or assets based on the predicted prices of an underlying index. Unlike the stock market, financial futures trade six days a week, Sunday through Friday, and nearly around the clock. The Dow is often considered synonymous with “the stock market,” though the S&P 500 Index, which is comprised of at least 500 constituents, more broadly represents the U.S. equities market.
A futures contract is a legally binding agreement between two parties in which they agree to buy or sell an underlying asset at a predetermined price in the future. And the value of the underlying asset—in this case, the Dow—will usually change in the meantime, creating the opportunity for profits or losses. Investors cannot just check whether the futures price is above or below its closing value on the previous day, though. Ex-dividend dates are not evenly spread over the calendar, either; they tend to cluster around certain dates. On a day when several big index constituents go ex-dividend, index futures may trade above the prior close but still imply a lower opening. Just because index futures have a fair value doesn’t mean they trade at that price.
Opening a Futures Trading Account
Market participants use index futures for many different purposes, including hedging, adjusting asset allocation through index futures overlay programs or transition management, or outright speculation on market direction. Index futures are more liquid than the market in the index’s individual components, so investors in a hurry to alter their equity exposure trade index futures—even if the price isn’t equal to fair value. Once banks and brokers calculate interest costs and dividends, they establish a fair value number, such as plus 10, for example. That means if the futures are plus 5 for the morning, and the fair value number is plus 10, then stocks could actually open lower.
However, most days don’t offer market-moving economic reports or random non-financial events that have effect on the market. Futures markets aren’t burdened with the same short-selling regulations as stock markets. If you expect the DJIA to go up, buy a futures contract; if you expect the index to decline, sell one short. Take a position in the futures contract trading month https://www.tradebot.online/ you want to trade—the one with the closest expiration date will be the most heavily traded. In low-volatility markets with no significant economic reports, S&P futures may only vary from the previous close by a few points. In these cases, the cash market close will be more influenced by large institutions taking profits or adding to positions during normal trading hours.
If you have little exposure to the futures market, you may, at first, feel perplexed by Dow Futures. Each week, Zack’s e-newsletter will address topics such as retirement, savings, loans, mortgages, tax and investment strategies, and more. The Dow Futures provide an indication of where the stock market is headed before it opens.