Five Things Every Investor Should Know About Index Futures

To navigate the markets confidently, you need to understand that just because the futures contracts are rising or falling, it does not mean that the market will rise or fall.

When you see futures data, what you need to zero in on is the relationship between the futures and the futures' fair value . If the futures are selling at a premium, this indicates that stocks will have an upward bias to close the gap between the cash value of the index and the fair value of the future and to eliminate the premium. If the futures are selling at a discount, this indicates that stocks will have a downward bias to close the gap between the cash value of the index and the fair value of the future and to eliminate the discount. In either case, the market will seek to establish fair value equilibrium.

If the market does not take care of the process of returning the markets to equilibrium, then a special group of traders called index arbitrageurs (or "arbs") will step in and do so. At premiums , the index arbs will buy stocks and sell futures. At discounts , the index arbs will sell stocks and buy futures.

This knowledge will help you gain an edge in anticipating market moves in the short term.

5. Index Futures Are Not a Type of Option

It is a common misconception by beginning investors that futures are some sort of special type of option . They're not.

Futures place obligations upon each party in the transaction, while options have conditional aspects, which give one party a choice and the counterparty a potential obligation. Futures allow parties to buy or sell an asset in the future at a certain price, which is negotiated today. On the other hand, options are used to speculate or hedge an asset based on a multi-factored set of characteristics, such as time, strike price and direction (put or call ).

Also, unlike with options, with index futures, there is no need to factor in the concepts of volatility or strike price (see "When I Trade Options, Am I Overpaying?").

(To learn more about futures, check out "Ask TheStreet: Future Feature" and "Booyah Breakdown: Looking Into the Futures.")

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