Five Things Every Investor Should Know About Index Futures
3. Index Futures Can Be Improperly Priced
Let's say that the fair value for the three-month SPX future is $1,616. Suppose that the future is now trading at $1,610. This implies that it would be cheaper to buy the future today with a contract price of $1,610 (remember, you don't have to pay that right now) rather than borrow $1,600, pay three months of interest and offset that with earned dividends. When the futures price ($1,610) is below the fair value of the future ($1,616) the future is said to be trading at a discount.
Now let's change the scenario. Say the SPX future begins to trade a $1,620. This would imply that it would be cheaper to buy the SPX stocks today for $1,600, pay the $24 of interest and receive the $8 in dividends rather than contract to buy the index in three months for $1,620. So what? When the futures price ($1,620) is above the fair value of the future ($1,616), the future is said to be trading at a premium.
4. Discount or Premium? It MattersMarkets are not going to stand idly by when futures are not properly priced. So you need to know how markets react to changing conditions in the futures markets. Futures are traded on futures exchanges during business hours as well as on electronic exchanges, such as Globex. When you tune into CNBC, Bloomberg or almost any another financial media outlet, the SPX index futures value will typically be displayed. In addition, you might see an indication of whether the futures are trading at a premium or a discount.
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