Five Things Every Investor Should Know About Index Futures

Dividends: The current dividend yield on the SPX is around 2%. For this basic example, here are a few simple assumptions:

• Dividends are distributed on a continuing amortized basis. That is to say that the 2% dividend will be earned evenly each and every day over the next 365 days.
• Dividend rates are fixed, and companies will not increase or cut dividends at any time.

With this in mind, you can expect to earn $8 (2% of $1,600 times 25%) in dividends at the end of the three-month period that would coincide with the futures contract you are considering. So if you bought the SPX today, you would earn $8 in dividends over the next three months. On the other hand, if you bought the futures contract, you would forgo any dividends on the index.

In these simple terms, you can now calculate the fair value of the SPX index futures contract. If you bought the SPX today, you would pay $1,600 for the purchase, incur $24 in interest charges and earn $8 of dividends. Your net cost would be $1,616 ($1,600 plus $24 minus $8). Again, it probably wouldn't make much difference to you whether you bought the SPX at $1,600 today or bought a futures contract to buy the index at $1,616 in three months.

Of course, things are not that simple in the real world. Consider these points:

• Interest rates vary from individual to individual and institution to institution.
• Dividends are not constant. Companies will pay dividends on any day they choose. Some companies pay quarterly, while others pay on an annual basis.
• Dividends are not certain. Companies can raise, lower or omit dividends.

The above shifts are factored in by market participants to arrive at a fair value for the index futures. Understanding this, you can now determine whether the futures are priced for a market move, and if so, the direction of the move, as well as the extent to which the futures are mispriced relative to the underlying cash index.