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Back to the Future(s)

The first stock-index futures contracts went on sale 36 years ago today, on 24 February 1982, when the Kansas City Board of Trade started allowing for the trade of these contracts.  Futures have been around for awhile, but making them available on an entire index opened them up to a whole new type of investor.

Simply put, a futures contract is an agreement to buy or sell a specified product on a particular date at some point in the future.  Historically, futures contacts were essential in keeping the commodities market functioning: farmers could sell contracts for their produce before it was harvested, and use some of that money to pay for harvesting costs, secure in the knowledge that their crop will have a buyer.  Stock futures do the same thing for a particular stock, while stock-index futures so that for an entire index, like the S&P 500 or NASDAQ.  Futures tend to pick up in volume whenever markets enter into periods of uncertainty, because they are inherently forward-looking investments that rely upon prices changing in order to make a profit.

One of the biggest differences between futures and actually buying a stock or index, aside from timing, is the cost to investors.  Typically, futures operate on margin, meaning that the investor only needs to put down around 10-20% of the actual cost for the contract upfront.  In the futures market, your purchasing power is much greater than in the regular stock market.  While this amplifies potential gains, it also amplifies potential losses - if the price of the underlying stock or index declines enough, you can even lose more than the value of your initial investment.  For this reason, futures are considered high-risk investments, best for advanced investors or those with high risk tolerance.  Since speculating on futures is so risky, many investors who buy and sell futures will typically use various hedging strategies in order to minimize their potential risk.

The simplest form of hedging involves the investor simultaneously buying two opposite positions on the same investment.  For example, they might buy a stock, and also sell a future on that stock at the same price, protecting themselves against a potential decline in the stock price.  Investors can also strategically use different types of spreads to mitigate risk:

  • Calendar spread: combines short- and long-term futures contracts that alternately buy or sell the same stock at different times, taking advantage of differences in short- and long-term price trends.
  • Intermarket spread: involves futures to both buy and sell stock, but on two different firms in related markets on the same delivery date.  If one industry is experiencing difficulties, the other might be performing better.
  • Matched pair spread: buys futures contracts on two directly competing firms, in the hope that one company's loss will mean the other's gain.

Individual investors looking to get involved with futures contracts must be ready to research each purchase in-depth, and monitor their accounts carefully to ensure that they are maintaining margins on all of their existing contracts.  Prices of futures can change much more quickly than stocks, and so they require constant, diligent monitoring.  Alternatively, you can hire an investment advisor.  A professional advisor can deploy multiple advanced investment strategies, and actively monitor your accounts.