Using Index Futures to Predict the Future 5.00 / 5 (100.00%) 1 vote

Many investors. especially less-experienced ones, tend to view index futures with a lot of suspicion and prefer to stay away from them. Its quite true that futures are wrought with risk and uncertainty, and have been known to sink even highly experienced professional traders. However, unknown to many traders also is the fact that using index futures can be a very useful predictive tool. An index future contract binds two parties to a specific agreed value for the underlying index that will be executed at a set future date. Like many derivatives, future indexes are essentially a zero-sum game: one party is long while the other is short. The loser must agree to pay the winner the difference between the agreed future price and the closing price of the index future at the time of expiration.

Major Differences between Equities and Index Futures

There are some major differences between trading in stocks and trading in index futures. Although index futures are closely correlated to their respective underlying indexes, they are not identical. Futures, unlike stock, trade at a huge margin. A trader who buys index futures only has to pay 5% of the principal amount of the futures, unlike stocks which require the trader to pay the full amount. The only time that the price of the index future must equal the value of the underlying index is at the time of expiration. At any other time, the futures contract bears a fair value relative to the index, reflecting the foregone dividends.

The index arbitrage usually keeps the price of the futures close to their fair value only when the futures and their respective stocks trade at the same time. Index futures trade 24/7 on platforms such as Globex, unlike stocks which trade from 9.30am Eastern Time and close at 4pm Eastern Time. Futures usually exhibit higher volatility once the stock market closes because arbitrage opportunities are no longer there.

Using Index Futures to Predict Stock Prices

Index futures are available for major indexes such as the S&P 500, and the NASDAQ Composite. They tend to be excellent tools for predicting short-term prices of their underlying stocks, such as the opening price. Trading is usually very volatile early in the morning and is accompanied by bigger-than-normal price swings. A lot of trading activity takes place in the early trading hours. But quite often, the market impact by huge buys or sell activities by large investors is usually enough to offset the impact by index futures. For stocks with little trading activity, however, index futures can have a discernible impact on their prices.

Futures are also useful as predictive economic tools, and can be used to get a glimpse of vital economic data such as the rate of inflation. When people talk of commodity prices of things like gold, cattle, timber, oil and so on, they really are talking about futures prices because commodity prices are directly related to the inflation rate. If you are paying more now for certain commodities than was the case a few months ago, it means that the inflation is on the rise. If future contracts for things like oil, precious metals, silver and others are rising, then the cost ends up being passed to the consumer.

Using index futures to predict the future is a tried and proven economic indicator, although it does not give hints why things are going the way they are.