Indexing the Future

Every morning, I see stories like this one describing how trading in "stock index futures," predicts the movement of the market. But what, exactly, is a stock index future and how does it predict what the market will do?

A stock index future is a futures contract tied to a stock index. I know, that doesn't help very much, does it?

A futures contract is an agreement to buy something in the future at a price set now. For example: imagine that last year you made an agreement with your local gas station - you agreed that in one year you would buy 100 gallons of gas for $3.00 per gallon. You have, essentially, made a bet that gas will cost more than $3.00 when it comes time to settle up.

An index is a mechanism for measuring price fluctuations of the market as a whole. An equity index, like the S&P 500, tracks the performance of a hypothetical portfolio of stocks. The portfolio is composed of the stock of 500 large companies. For more on the S&P 500 click here.

In 1982, the Chicago Mercantile Exchange debuted a futures contract designed to track the price of the S&P 500. They work like this: you sign a contract to buy a basket of stocks resembling the S&P 500 at today's price. The amount you'll pay is arrived at by multiplying today's S&P 500 index number by 250 (it comes out to nearly $400,000 per unit). But, you don't wait until the end of the contract to find out if you're ahead or behind. The CME adjusts the contract price every morning based on closing price of the S&P 500 from the day before. If today's close is higher than yesterday's close, they put money in your account. If the price goes down, they subtract. This goes on until the end of the contract.

This is how we get to stock index futures as a predictor of tomorrow's market. Daily resetting, coupled with the fact that the contracts can be traded make them a way to gamble on whether today's closing price will be above or below yesterday's. For instance, if you think the market will end down compared to yesterday you might try to unload your index futures before the CME debits your account.