Opening indications for the stock market are frequently dictated by futures activity, which takes place after the prior trading day's close or overnight through early morning, before the new markets open.

So what?

The futures market is the quickest and easiest way for large asset managers (see portfolio manager ) and speculators to react to an event, such as a Federal Open Market Committee statement, a company report that significantly beats or misses earnings estimates (see earnings surprise ), a tragedy or some other major occurrence.

For these reasons, as an individual investor, you need to be more aware of the futures markets.

In the early to mid-1980s, working at Morgan Stanley ( MS), I was involved with the equity index arbitrage business while it was in its infancy, so I have a great deal of experience in futures. I thought that I would use this installment of "The Finance Professor" to describe five ways to better understand what index futures and index arbitrage are and how these futures can affect you.

1. What Index Futures Are

A futures contract is a highly leveraged derivative investment that is transacted by hedgers , speculators and arbitrageurs . The contract represents an obligation on the part of the seller to deliver an asset to the buyer in exchange for a predetermined price.

Commonly traded classes of futures are grains (wheat, soybean, corn); metals (gold, silver); livestock (pork bellies, live cattle); financials (equity index, government bonds, Eurodollars); and exotics (weather, pollution emissions).

Equity index futures are a type of financial future that tracks popular broad-based indices, such as the S&P 500 ( SPX), the Russell 2000 ( RTY) and the Nikkei 225 ( NKX).

Also, equity index futures contracts are cash settled, which means that upon expiration -- rather than upon delivery of assets as with the S&P 500 stocks -- a final cash gain and loss is passed between the contacting parties.

2. Futures Pricing: Cheaper Now or Later?

As the name implies, futures represent some forward valuation of an asset. This raises the question, "Is it cheaper to buy the asset today or in the future?" Thus, we have to begin the process by determining a break-even or fair value price for a future relative to the current spot price (or cash price). In order to do so, you have to consider two important variables: interest and dividends .

Interest: Let's say that the spot price for the SPX is currently $1,600 and you are contemplating the purchase of a futures contract with a maturity date of exactly three months from now. Currently, you can borrow money at your corner brokerage or bank at a rate of 6% for a three-month maturity. So if you borrowed $1,600 today, then in three months' time (a quarter of a year), you would have to return $1,624 to the lender ($1,600 plus 6% of $1,600 times 25%). Thus, in a world devoid of dividends, with so little interest accrued, you would probably be indifferent to whether you paid $1,600 for the SPX today in the current market or $1,624 for the SPX in the future.

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.

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 Matters

Markets 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.

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 .")
At the time of publication, Rothbort was long SPY (the ETF corresponding to SPX), although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at Scott appreciates your feedback; click here to send him an email.

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