The Standard & Poor’s 500 (S&P 500) is the largest and most important stock market index. It tracks the performance of the 500 largest companies listed on US stock exchanges. Not only is it the most traded index, but also the ultimate benchmark for thousands of funds and fund managers. The index’s market capitalization was $36.41 trillion as of September 30, 2021.
Futures contracts are financial derivatives. They bind the parties to trade an asset at a predetermined future date and price. Regardless of the current market price at the expiration date, the buyer or seller must purchase or sell the underlying asset. There are futures for a wide variety of underlying assets. This includes physical commodities and other financial instruments. Futures contracts specify the underlying asset’s amount. They are standardized to allow trading on a futures exchange. Futures contracts can be used for both hedging and trading purposes. Traders can use this instrument to fix the price of an underlying asset or commodity and have pre-determined expiration dates.
In 1997, the CME introduced E-mini futures, which are electronically traded futures that are a fraction of the value of corresponding standard future contracts. The purpose was to allow smaller investments and to reach a wider range of investors. Many traders favour the S&P 500 E-Minis, not only because of its smaller investment size but also because of its liquidity.
How to trade S&P 500 futures
The process to start trading futures is the same as for any other instrument. The first step is to open an account with a broker covering the markets one wants to trade. As the S&P 500 index is a widely traded index due to its size, finding a broker offering S&P 500 futures won’t be a challenge. The broker will then ask about investing experience, income and net worth. These questions are designed to determine the risk the broker will allow the trader to take. There is no industry standard for commission and few structures in futures trading – this varies from broker to broker.
The price of S&P 500 futures are calculated by multiplying the S&P 500’s value by $250. For example, if the S&P 500 is at 2,500, then the market value of a futures contract is 2,500 x $250 (i.e. $625,000). To take a position in this, investors must only put up a fraction of the contract value. This is what is called the margin on a futures contract. These margins are not the same as margins for stock trading. Futures margins represent “skin in the game” that must be offset or settled.
As for E-Mini contracts on the other hand, they represent one-fifth of the value of the big contracts. If the S&P 500 level is at 2,500, then the market value of a futures contract is 2,500 x $50 (or $125,000).
Before committing real money, it is often advised to open a virtual trading account and practice trading with “paper money.” This is an important tool to understand the futures markets. It also helps to understand how markets, leverage, tax, and commissions interact with one’s portfolio.
Some important concepts for trading futures:
- Leverage: Using leverage means trading with borrowed funds. This allows high potential returns but also has the potential for significant losses. Futures markets are notorious for their use of excessive leverage.
- After-Hours Market: Futures markets trade at a variety of times throughout the day. Furthermore, futures markets can predict how underlying markets will open. For instance, stock index futures will tell traders whether the stock market will open higher or lower.
- Margin: the percentage of a transaction that a trader must keep in their account, also known as initial margin. Federal regulations set the minimum margin value at 50% of the total transaction cost. Yet, brokers and exchanges can set their levels higher if they desire.
As an example, a trader can have $50,000 in their brokerage account, and they can borrow another $25,000 in leverage. Then, enter a trade worth $75,000 less any amount the broker requires they hold in abeyance, as margin in the account.
Newcomers should also be aware of the following:
- Trading futures requires more minimum capital than other instruments used in day-trading.
- Futures are very volatile, so a risk-management strategy to mitigate losses is essential. In addition to the daily trading signals, daily stop losses are provided for risk management. The use of these is recommended but discretionary.
Advantages of trading S&P 500 futures
One of the frequently touted advantages of trading S&P 500 futures is that each contract represents an immediate, indirect investment in the performance of the 500 stocks that comprise the S&P 500 Index. Investing in specific S&P index companies may not always be feasible or desirable for many investors. Investors can take long or short positions depending on future price expectations.
Future contracts are traded in large quantities every day, making it a very liquid market. Because buyers and sellers are always present in the futures markets, market orders can be placed quickly. This also means that prices do not fluctuate dramatically for contracts nearing maturity. As a result, large positions can easily be cleared without affecting the price.
Many futures markets are not only liquid, but they also trade outside of traditional market hours. Extended trading in stock index futures often occurs overnight, with some futures markets operating 24 hours a day, seven days a week.
Future trade commissions are very low and are charged when the position is closed. Typically, the total brokerage or commission is as low as 0.5 percent of the contract value. However, this can depend on the broker. A commission for online trading can be as low as $5 per side. Full-service brokers can charge up to $50 per trade.
Finally, there is the possibility to short sell using future contracts. This cannot always be done with all stocks due to different regulations or difficulties in borrowing the stocks.
Disadvantages of trading S&P 500 futures
While trading on margin means that the trader doesn’t need to deposit the whole desired amount, trading with leverage means that potential profits are magnified. It is important to remember that it can be a double-edged sword and that losses are inflated as well.
Futures contracts are complicated and can be difficult for new traders to understand. Each contract has a different size and different price movement amounts. Traders have to understand final trading dates and possible delivery options.
To summarise
- Futures are one of the most common ways to trade the S&P 500.
- There are two types of futures. Standard futures and E-Mini futures, designed for traders looking for smaller ticket sizes.
- Future contracts are more complicated than the underlying assets they track. As a result, a thorough understanding of all risks and concepts involved is required.
- While futures can present unique risks to investors , there are several advantages to trading futures over trading straight stocks including greater leverage, lower trading costs, and longer trading hours.
Disclaimer: This content is for information purposes only. It is not an investment recommendation and not a call to action to invest in the financial market.
