Index futures are financial derivatives that allow investors to wager on the direction and magnitude of an underlying index. Investors can do this without actually owning any specific stocks or indices included in the index, making them a popular option for risk-averse investors. Index futures offer traders various potential opportunities, from hedging portfolios to speculating price movements. It is essential to understand how these contracts work and the different advantages they have.
Types of index futures
There are several types of index futures, each with advantages and disadvantages.
Stock index futures
A stock index future is a financial contract that allows investors to speculate on the value of equity indexes such as the NASDAQ, S&P 500 or the Dow Jones Industrial Average. As these indices comprise many stocks, they offer greater diversification and lower risk than individual stocks.
Commodity futures are contracts where traders agree to buy a particular commodity at an agreed-upon price on a specified date in the future. These contracts can be used as hedging strategies against commodities and raw materials price volatility in futures trading. For example, traders may use copper or crude oil index futures to protect against losses due to changing prices.
Currency futures enable investors to speculate on changes in exchange rates. Futures contracts are based on an underlying currency pair, such as the US Dollar/Singapore Dollar or Euro/Swiss Franc. Investors can use these contracts to hedge against exchange rate risk and speculate on currency movements.
Interest rate futures
Interest rate futures are financial derivatives that allow investors to bet on changes in interest rates. This type of future price is linked to an underlying reference rate such as the London Interbank Offered Rate (LIBOR) or Federal Funds Rate. They provide investors with a way to manage their portfolios against fluctuations in interest rates.
Value of index futures
The value of an index future refers to how much money can potentially be made when choosing to trade using the index. Generally, index futures are considered highly valuable instruments, as traders can capitalise on market movements without owning any underlying financial instruments. The following benefits contribute to the advantages and value of index futures.
Index futures can be used as hedges against portfolio losses due to changing prices. Investors can use these contracts to buy and sell index futures at a specific price to protect their portfolios from losses due to changing prices.
Speculating price movements
Index futures allow investors to speculate on future market trends and movements without owning any stocks or indices tied to the underlying index. It allows them to take advantage of short-term price changes while avoiding the risks associated with long-term investments.
Index futures are leveraged instruments, which means that investors can use a small margin to control a much more significant amount of the underlying asset. It allows investors to make larger trades with less capital in order to help significantly increase their bottom line.
Low transaction costs
Index futures have lower transaction costs than other trading instruments, such as stocks and ETFs. It makes them an attractive investment option for those looking to maximise their advantages while minimising risks.
Investors may benefit from tax advantages when investing in index futures due to the contract’s limited life span. Gains generated from index futures transactions are taxed at lower rates than traditional investments.
Index futures risks
While there are several benefits of investing in index futures, investors must know about the risks involved. Knowing the risks allows investors to make better decisions and limit their losses. As with any investment, investors must research the underlying asset before entering into a futures contract.
Index futures prices can change significantly from one day to the next, meaning investors may be unable to accurately predict future price movements and suffer significant losses due to unexpected price changes.
Margin call risk
Since index futures are leveraged instruments, investors must maintain a certain amount of margin to keep their positions open. If the value of the contract drops below this margin requirement, the investor will incur a margin call which requires them to top up the difference or exit their position.
Index futures have low liquidity, meaning it may be difficult for traders to close their positions if the market moves against them, resulting in losses and further financial damage if the trader cannot exit their position in time.