Money, Cash & Finance

Most people have heard the futures market mentioned on TV occasionally. However, a lot of people dont understand what the futures market is. Learning how to utilize it properly will help with entry timing when day trading, swing trading, and even investing (after all, who wants to be down immediately after entering a position?)

It’s actually quite simple. The futures market is just a bet on where an index will close at a future date in time. It is no different than saying ” I think GE will be 5 points higher in 3 months”. Now imagine thousands or people, or even hundreds of thousands all betting on where GE will be in 3 months. Not tomorrow, the time is 3 months from now.

This aggregate valuation call would be considered a futures market. It may be higher or lower than where GE is now, but you also have to consider the people have 3 months to be right - that is a lot of time. Time always has a value, because the more time you give yourself to be right, the easier that bet is. The market puts this time value into the price of the futures, each day that goes by a fraction of that is taken out. This 3 month time in this example is a fixed time, it does not scroll forward. So if the bet is a close of at least X price by july 31st, 2 weeks from now the date to be right is the same but the time left is less.

If this still seems confusing, think about this example:  Every day an analyst says “The market will fall 300 points today."  If that happens in 1 day, he gets a bonus of $40,000.00.  The more days you give him to be right, eventually, even just by random chance, he will be right.The time increase you might give a person to be right would actually decay the value of the prediction being right.If the guy is given 1 month to be right, that is only worth $10,000.00.It the time to be right is 3 months, that is only worth $1000.00.00 and so forth, this is a type of time decay.

This basic concept is then carried over to the stock indexes. Traders and investors place bets based on current and anticipated information and research for what they think the value of the index wil be in the future. One key to always remember - futures and cash are equal on expiration as the futures are converted into cash value. So if the S&P 500 index is at 1400 on expiration, so will the futures contract trade to this price. Because of this, that difference can be arbitraged between the two (cash and futures) since they trade separately. Anyone can make a bet on the futures market without even touching the cash index or stocks. In just the same way, I can buy a large basket of stocks in the index without touching the futures market. This give and take causes the 2 of them to fluctuate independently.

If the futures push to high relative to stocks (the spread widens), there is free money since at expiration the value is equal. The idea is to sell the futures and buy the basket of stocks that comprise the index and lock in the free money if held until expiration. There are whole other program trades that simply day trade stocks vs futures all day long based on the premium to cash being too high or too low.  By selling the futures, you have agreed in principal to sell the basket of stocks comprising the index at that futures price. If the futures are 1430 and the cash is 1400, and the time value is 20, theoreticaly the futures should be at 1420. At 1430, I can sell the futures, then buy the stocks and lock in 10 points for free. Doing it in real time is not this easy, but the basic underlying concept is.  Anyone who wants to learn to trade needs to understand how the futures market works.