An indexed contract tends to contain fewer options than a fixed-price contract: the difference between the contract price and the market price is generally smaller and less volatile. This reduces arbitrage trading opportunities in the market and therefore the value of the option. Index futures are futures contracts where a trader can buy or sell a financial index today to be settled at a future date. Traders use index futures to speculate on the price direction of an index like the S&P 500. The index may consist of settlement prices from a stock exchange or price evaluations from an agency such as Platt`s, Argus or ICIS Heren. It is important to choose the right price for the index. First, market prices must be published now and in the future by a trusted organisation using a transparent methodology. Second, the index market must be sufficiently liquid so that no party can easily manipulate the price level of the index. Finally, if the index market (e.g. Henry Hub) is different from the physical market (a local hub), it must be highly correlated with the physical market or have a strong correlation with buyer engagement. Stock index futures are settled in cash, which means that the underlying asset is not delivered at the end of the contract. If, at expiration, the price of the index is higher than the agreed contract price, the buyer has made a profit and the seller – the future writer – has suffered a loss. If it is the opposite, the buyer suffers a loss and the seller makes a profit.
An investor decides to speculate on the S&P 500. S&P 500 index futures are valued at $250 multiplied by the value of the index. The investor buys the futures contract when the index is trading at 2,000 points, resulting in a contract value of $500,000 ($250 x 2,000). Since index futures do not require the investor to set up all of the 100%, he only needs to hold a small percentage in a brokerage account. Index futures prices can fluctuate significantly until the contract expires. Therefore, traders need to have enough money in their account to cover a potential loss called maintenance margin. The maintenance margin sets the minimum amount an account must hold to satisfy future claims. Imagine a hypothetical index called Index X, which currently has a level of 500.
Suppose an investor decides to buy a call option on the X index with an strike price of 505. If this 505 call option is valued at $11, the entire contract will cost $1,100, or $11 x a multiplier of 100. The winnings are determined by the difference between the entry and exit prices of the contract. As with any speculative trade, there is a risk that the market will move against the position. As mentioned earlier, the trading account must meet the margin requirements and could receive a margin call to cover the risk of further losses. In addition, the trader should understand that many factors can affect the prices of market indices, including macroeconomic conditions such as economic growth and profits or company disappointments. Index call and put options are popular tools for trading the general direction of an underlying index while putting very little capital at risk. The profit potential for index call options is unlimited, while the risk is limited to the premium paid for the option. With index put options, the risk is also limited to the premium paid, while the potential profit is limited to the index level, minus the premium paid, as the index can never fall below zero. The risk associated with this transaction is limited to $1,100. The break-even point of an index call option transaction is the strike price plus the premium paid.
In this example, it is 516 or 505 plus 11. At any level above 516, this particular trade becomes profitable. Outside the US, there are futures contracts for the DAX Stock Index of 30 major German companies and the Swiss Market Index (SMI), both traded on Eurex. In Hong Kong, Hang Seng Index (HSI) futures allow traders to speculate on the most important index in this market. Index futures are derivatives, that is, they are derived from an underlying asset – the index. Traders use these products to trade various instruments such as stocks, commodities and currencies. For example, the S&P 500 Index tracks the stock prices of 500 of the largest companies traded in the United States. An investor could buy or sell index futures on the S&P 500 to speculate on the appreciation or depreciation of the index. Portfolio managers often buy stock index futures to hedge against potential losses. If the manager has positions in a large number of stocks, index futures can help hedge the risk of falling stock prices by selling stock index futures. Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stock prices fall.
In the event of a market downturn, the stocks in the portfolio would lose value, but the index futures sold would increase in value and offset the losses of the shares. It is important to note that the underlying asset of this contract is not a single share or a series of shares, but the cash level of the index adjusted by the multiplier. In this example, it is $50,000 or $500 x $100. Instead of investing $50,000 in the shares of the index, an investor can buy the option at $1,100 and use the remaining $48,900 elsewhere. This sample agreement is courtesy of Kate Mertes. An index futures contract states that the holder agrees to buy an index at a certain price at a specific future date. Index futures are usually settled quarterly, and there are also several annual contracts. Stock index futures naturally work differently than futures on tangible goods such as cotton, soybeans, or crude oil.
Holders of long commodity futures positions must take over physical delivery if the position has not been closed before expiration. Therefore, there are more variables to consider as the option and futures contract have futures maturities and their own risk/return profiles. With such index options, the contract has a multiplier that determines the total premium or the price paid. Usually, the multiplier is 100. However, the S&P 500 has a 250x multiplier. An index option is a financial derivative that gives the holder the right (but not the obligation) to determine the value of an underlying index, such as .B. of the S&P 500 Index, to buy or sell at the stated strike price. No real shares are bought or sold. Often, an index option uses an index futures contract as the underlying asset. Unforeseen factors can cause the index to move in the opposite direction to the desired direction. If the index level is at expiration 530, the owner of this call option would exercise it and receive $2,500 in cash on the other side of the transaction or (530 – 505) x $100. Less the initial premium, this transaction results in a profit of $1,400.
Depending on the portfolio and activities of the buyer and seller, an indexed contract is good for risk management. For example, if the buyer wants absolute price security for the duration of the contract, it is safer to buy at a fixed price. However, if it still wants to be close to the market, then an indexed contract is the best choice. Index futures allow speculation on the price movement of the index. Advanced financial methods are needed to calculate the value of market options, price risks and the day-to-day management of indexed contracts. KYOS is a specialist in this field with its KYOS Analytical Platform and KySwing software products. The fund manager could hedge or only partially offset all downside risks in the portfolio. The disadvantage of coverage is that it reduces profits when coverage is not needed.
Take, for example, the scenario above. If the portfolio manager sells index futures and the market rises, index futures would lose value. Hedging losses would offset portfolio gains as the stock market rose. Index futures, like all futures, give the trader or investor the power and obligation to deliver the current value of the contract based on an underlying index at a specific future date. If the contract is not settled before the expiry by a clearing transaction, the trader is obliged to deliver the current value at expiry. Speculation is an advanced trading strategy that is not suitable for many investors. However, experienced traders will use index futures to speculate on the direction of an index. Instead of buying stocks or individual assets, a trader can bet on the direction of a group of assets by buying or selling index futures. .