A brief introduction

Most traders, investors and speculators are familiar with the concept of an index which is generally associated with a particular exchange, and which is widely reported on a daily basis as giving a snapshot of the performance of equity markets for the day. So for example, in London the leading index which is reported is the FTSE100, which is based on the 100 largest companies quoted on the London Stock Exchange by market capitalization. Below this there are several others including the FSTE250 and the FTSE 250 which reflect the performance of smaller sized companies. In the US, there are several indices quoted including the Dow Jones Industrial Average based on 30 of the largest US companies quoted on the NYSE, along with the S & P 500 index, the Nasdaq 100 and many more. In Japan the leading index is the Nikkei225 and in Australia it’s the All Ordinaries index, and whilst these indices cover exchanges and markets around the world, they all have one thing in common, which is how they are constructed, and generally this is using the ‘free float’ method.

The free float methodology is now the most widely accepted form of best practice for index construction, and is used throughout the world on all the major indices such as the FTSE, the STOXX, S & P 500 and the Dow Jones. In simple terms free float is defined as that proportion of the total number of shares issued by a company which are freely available for buying and selling in the market. In other words it excludes all those government holdings, strategic holdings and other shares which are locked in and not available to the market. In the UK for the FTSE 100, the factor used is often called the free float adjustment factor, which represents the number of shares floated or freely available, as a percentage of the number of shares issued.

This is then rounded up to the nearest 5% for calculation purposes. To calculate the index level for the FTSE 100 a simple formulae is applied which is as follows: FTSE 100 Index Value = Total sum of (share prices x shares issued x free float factor)/index divisor. The formula uses a divisor called an index divisor which simply links the index back to its original base year for comparison purposes over time, and in the case of the FTSE 100 the base value is 1000 which is where the index started when it was first created in 1984. This is calculated every 15 seconds during the ftse trading session.

The next element you need to understand as an index trader, is that of market capitalization. As explained previously, all the constituent shares are weighted to form what is called a capitalization weighted index. In simple terms what this means is that each share contributes its market value to the index so that the larger the company then the greater the weight they carry as a result.

In order to outline how all the above works let’s take a simple example and suppose we are developing a new index with two shares, Great Mining plc (GM) and Profitable Oil (PO) plc. Suppose that Great Mining plc has 1000 shares, but 200 of these are not freely available to the market, and similarly Profitable Oil plc has 2000 shares, with only 1000 shares freely available. Then the free float value number of shares for GM plc is 800, whilst for PO this is 1000. Next let’s assume the share price for GM is 120p and for PO is 200p, then the free float market capitalization of GM plc is ( (1000 – 200) x 120) = 96,000 , and for PO plc it is ((2000 – 1000) x 200) = 200,000. If we then add these two figures together we arrive at our free float market capitalization for our new index at 200,000 + 96,000 = 296,000, and as this is a new index we can now decide on our index divisor in order to reduce the index to a more manageable number, so in this case we could assume 1000 to start, as for the FTSE 100 and arrive at our index value for today of 296,000/1000 = 296.

This in very basic terms is how the index is calculated using the free float method with weighted market capitalization of the constituent shares, and in our simple example Great Mining plc would represent 32.5% of the index whilst Profitable Oil plc would represent 67.5%. On a simple share price comparison basis then the ratio would be 40%/60%, but using the above comparison provides a more balanced and weighted view of the index, which is why it is widely used throughout the industry.

Now in order to trade an index, we would need to hold all the underlying equities in the correct weightings, an almost impossible task, and this is where index futures step in, to offer us a simple instrument with which to trade an index without having to worry about holding the underlying cash assets on which it is based.

Index futures

Stock index futures were introduced in 1982 on domestic futures exchanges and have since grown to become the second most popular instrument for traders and speculators, behind interest rates, which remain the primary market within the futures market.

In fact the concept of a stock index future had been discussed many years prior to 1982, but due to a variety of regulatory and intellectual property issues, the instrument was delayed until these problems had been overcome.

These included such issues as the application of cash settlement mechanisms, jurisdiction issues between the CFTC ( Commodity Futures Trading Commission) and the SEC( Securities and Exchange Commission), and finally rights issues centered on the intellectual property of index publishers.

Once these had been resolved, the first index future was launched on the KCBT, the Kansas City Board of Trade, followed almost immediately after by the Standard and Poor’s 500 index on the CME. Once the basic concept of a stock index had been created, the instrument was then replicated on both domestic and global exchanges around the world. As a result, we now have a huge array of stock index futures covering every major exchange, and which can be accessed by institutional and retail traders alike.

Index futures explained

So what is an index future? In simple terms stock index futures, or simply index futures, are contracts, just like any other futures contract, but this time the underlying ‘asset’ from which it is derived is an index rather than a commodity, currency or stock. So like all futures contracts, these are contracts to buy or sell the value of a specific stock index, at a specific price on a specific date in the future.

Index futures closely follow the price movement of their respective indices, which are generally referred to as the underlying cash market, as this is where real cash changes hands for the physical stocks. So for example in a FTSE future, the underlying index is the FTSE 100 index, or the cash market if you like, a DOW future has the Dow Jones Industrial Average as the underlying cash index, and finally of course an S & P 500 future will have the S & P 500 index as the underlying asset.

As a result, stock index futures closely follow the underlying cash index, and therefore correlations between the two are very close. On some occasions the  futures may diverge from the cash index for short periods of time, but generally, market forces, such as arbitrage, will usually work to bring these variances back in line very quickly.

One of the questions many index traders ask, is whether the cash index leads the futures index, or the futures market leads the cash market, and as this is where I began my own trading journey all those years ago, let me give you the definitive answer. The futures ALWAYS leads the cash, no if’s, no but’s, no maybe’s

So of course the question is why ? The simple answer is that the futures markets disseminate information much quicker than in the cash markets so market reaction to any news is seem in the futures first, and then followed by the cash. In addition, the futures markets act as the price discovery vehicles for the cash markets, so once again the futures will always lead. One simple way to prove this to yourself  is to have two screens or charts side by side with the cash index on one screen and the equivalent futures index on the other. Whilst the price movements may appear to occur simultaneously, what you will see in the volume indicator is accumulation or distribution ahead of any significant moves, as the futures markets prepares to move ahead of the cash market. This is why volume is a key indicator and vital to your success as it is the only leading indicator to reveal market intent and therefore future market direction.

The rise of the E-mini

Of all the futures contracts introduced on the CME exchange over the last thirty years, none have been more spectacular than E-mini series of index futures first introduced on the exchange in 1997 and now traded exclusively on electronic platforms such as the CME Globex system. In the space of ten years the trading volumes have grown from zero to regularly trade over 100,000 contracts per day. One of the most popular indices of course is the S & P 500, and when the first futures contract was introduced in 1982 this was based on a notional value of $500 times the index value. Over the years ofcourse as the index rose in value, so did the value of the futures contract, putting it well beyond the reach of most traders, before it was finally reduced to half this value in 1997, but still to high for many traders. In order to overcome the problem, the CME finally introduced the E-mini, with a multiple of only $50 times the index for the S & P, before being replicated on the Nasdaq100, the MidCap400 and the Dow Jones. The Nasdaq 100 E-mini has a multiple of $20 per index point, whilst the MidCap400 is the largest of the four at $100 per index point, with the E-mini Dow Jones being the smallest at $5 per index point.

All the above contracts are available virtually twenty four hours a day from Sunday evening through to Friday evening one the principle electronic platforms such as Globex, and the ticker symbols for each are as follows:

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Quotations and settlement

All the E-mini futures contracts outlined above are quoted in terms of the underlying cash index, so that the value of any futures contract is simply the contract multiplier times the settlement value of the underlying index. So for example if the Dow Jones cash index settles at 11,000 then the value of the E-mini Dow future contract is simply $5 x 11,000 or $55,000.

Each contract specifies the minimum price fluctuation allowable under the contract and these vary according to the futures contract being traded. Many of these are based on the concept of the tick being the smallest change in price and these are shown below as follows:

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So in the above examples, a tick change in the E-mini S & P 500 future would equate to a gain or loss of $12.50, so for each point move in the underlying cash index, the futures contract would gain or lose $50, whilst for the DJIA contract this would only be $5 per index point movement higher or lower.

Now as you would expect, index futures do not call for the physical delivery of the underlying stocks as this would be too cumbersome, and would also involve weighting these to tie in to the weightings in the index. All far to complicated. In order to overcome this problem, all index futures are settled in cash, and as is usual in the futures market, all contracts are marked to market at the end of the trading session, where profits or losses are calculated daily, and on expiry day positions are then simply cash settled at the spot value of the underlying index.