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# Index Futures 101

August 3, 2021
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“Index futures” is not a term that is too alien for anyone with basic knowledge of finance. It refers to a futures contract created on an index that functions as the underlying variable for such futures contract. For example, in Canada, the most popular stock index is the S&P/TSX 60 Index*, a stock index of 60 large companies listed on Toronto Stock Exchange (TSX). The futures contract that uses S&P/TSX 60 Index is known as SXF and is traded on the Montreal Exchange (MX).

However, like the above example, “index futures” is most commonly associated with a futures contract on a stock index. To say that an “index futures” only relates to a stock index will be a misnomer. After all, “index” is a generic term and could refer to a stock index, a bond index, a commodity index or even a cryptocurrency index. On a similar note, “index futures” could refer to a futures contract using either a stock index, a bond index or a commodity index as its underlying. In this article, we will focus on stock indexes due to their popularity.

An index (whether stock, bond or commodity) is a mathematical calculation that assigns weights to carefully selected constituents of the index on a certain basis. For example, a typical stock index assigns weights based on market capitalization. The weighted average of the prices of the constituents is known as the index value. The weights are revised periodically.

Since an index is merely a mathematical term, it can’t be bought directly. Instead, if one is willing to buy an index due to the expectation that index value will rise in the near future, one will have to buy all the constituents of the index. Such purchases can’t be in a random proportion. To match the index value, one must buy all the constituents of the index exactly in the same proportion as their respective weights in the index. For example, if the weight of a certain stock ABC in a stock index is 4.53%, then the buyer will need to allocate 4.53% of the total capital employed in the transaction for ABC.

Buying an index future is slightly different from buying an index. There are two notable differences. First, unlike an index, index futures expire. On the expiry, the trader either chooses to continue to be exposed to the movement of the index or to settle the trade. Second, index futures can be bought by paying a margin which is considerably less than the full value of the index.

Thankfully, all index futures are cash settled. This means when the index futures expire, a buyer doesn’t receive all the individual constituent stocks. Instead, the buyer enters into a final settlement and receives (or pays) the difference between the original purchase price and the final settlement price. Moreover, buying an index future is a lot easier than buying an index.

## Example

As indicated above, to execute such a trade, a trader pays the margin that is determined by the exchange. For example, both TSX standard futures (SXF) and S&P/TSX 60 Index Mini Futures (SXM) are based on the S&P/TSX 60 Index. SXF uses a multiple of C\$200 times the futures contract value while SXM uses a multiple of C\$50 times the futures contract value. The “M” in SXM stands for mini. Note that the margin set by the exchange is a minimum and a broker may ask its clients to deposit a higher margin.

Let’s take SXM as an example to understand how a typical trade will be executed. For a retail trader, the prevailing margin rate is C\$2,946 for 1 contract of SXM September 2021 futures. Let’s assume that at the time of this purchase, S&P/TSX 60 Index stands at 1190 while SXM futures trade at 1200. The trader will be able to buy 1 SXM September 2021 contract by paying C\$2,946 while the monetary value of the contract is C\$60,000 (i.e. 1200*C\$50)

## Potential Outcome

Let’s continue with our SXM example to understand the potential outcome of a long position i.e. a buy trade in SXM futures. The following table summarizes the potential outcome of a 10-point move on either side in the S&P/TSX 60 Index.

 +10-Points -10-Points Original Price 1200 1200 Purchase Value 1200 X C\$50 = C\$60,000 1200 X C\$50 = C\$60,000 New Price 1210 1190 Sale Value 1210 X C\$50 = C\$60,500 1190 X C\$50 = C\$59,500 Profit + C\$500 – C\$500

Clearly, the payoff is directly tied to the movement in the underlying index. Interestingly, the trader could make a profit of C\$500 using the capital of C\$2,946 instead of deploying the full contract value of C\$60,000. This simple merit of index futures has helped make them popular. Yet, index futures are not free from challenges and risks. In our next article, we will explore the challenges and tools pertaining to index futures trading.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

* The S&P/TSX 60 Index (the “Index”) is the product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and TSX Inc. (“TSX”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and TSX® is a registered trademark of TSX. SPDJI, Dow Jones, S&P, their respective affiliates and TSX do not sponsor, endorse, sell or promote any products based on the Index and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions or interruptions of the Index or any data related thereto.