Stock index futures can be used for this purpose. A stock index futures
contract is a futures contract in which the underlying is a specific stock
index. An investor who buys a stock index futures contract agrees to
buy the stock index, and the seller of a stock index futures contract
agrees to sell the stock index. The only difference between a single stock
futures contract and a stock index futures contract is in the features of
the contract that must be established so that it is clear how much of the
particular stock index is being bought or sold.
The underlying for a stock index futures contract can be a broadbased
stock market index or a narrow-based index. Examples of broadbased
stock market indexes that are the underlying for a futures contracts
are the S&P 500, S&P Midcap 400, Dow Jones Industrial Average,
NASDAQ 100 Index, NYSE Composite Index, Value Line Index,
and the Russell 2000 Index.
A narrow-based stock index futures contract is one based on a subsector
or components of a broad-based stock index containing groups of
stocks or a specialized sector developed by a bank. For example, Dow
Jones MicroSector IndexesSM are traded on ChicagoOne. There are 15
sectors in the index.
The dollar value of a stock index futures contract is the product of
the futures price and a “multiple” that is specified for the futures contract.
That is,
Dollar value of a stock index futures contract = Futures price
× Multiple
For example, suppose that the futures price for the S&P 500 is
1,100.00. The multiple for this contract is $250. (The multiple for the
mini-S&P 500 futures contract is $50.) Therefore, the dollar value of
the S&P 500 futures contract would be $275,000 (= 1,100.00
× $250).
If an investor buys an S&P 500 futures contract at 1,100.00 and
sells it at 1,120.00, the investor realizes a profit of 20 times $250, or
$5,000. If the futures contract is sold instead for 1,050.00, the investor
will realize a loss of 50 times $250, or $12,500.
Stock index futures contracts are cash settlement contracts. This
means that at the settlement date, cash will be exchanged to settle the contract.
For example, if an investor buys an S&P 500 futures contract at
1,100.00 and the futures settlement price is 1,120.00, settlement would be
as follows. The investor has agreed to buy the S&P 500 for 1,100.00
times $250, or $275,000. The S&P 500 value at the settlement date is
1,120.00 times $250, or $280,000. The seller of this futures contract must
pay the investor $5,000 ($280,000 – $275,000). Had the futures price at
the settlement date been 1,050.00 instead of 1,120, the dollar value of the
S&P 500 futures contract would be $262,500. In this case, the investor
must pay the seller of the contract $12,500 ($275,000 – $262,500). (Of
course, in practice, the parties would be realizing any gains or losses at the
end of each trading day as their positions are marked to market.)
Clearly, an investor who wants to short the entire market or a sector
will use stock index futures contracts. The costs of a transaction are
small relative to shorting the individuals stocks comprising the stock
index or attempting to construct a portfolio that replicates the stock
index with minimal tracking error.
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