What it means
Each contract has a fixed multiplier that converts index points into money. If the multiplier is $50 and the index stands at 4,800, one contract represents $240,000 of market exposure even though the trader posts far less than that to open it.
Nobody delivers a basket of shares at expiry. Index futures settle in cash against the official closing level of the index, so the loser simply pays the winner the difference in index points multiplied by the contract size.
The commercial use most finance teams and fund managers care about is hedging. A manager who expects a short-term fall but does not want to sell a portfolio, perhaps for tax or liquidity reasons, can sell index futures so that a gain on the futures offsets a loss on the shares.
Positions are marked to market every day, with profits credited and losses debited to the margin account. If the balance falls below the maintenance level, the broker issues a margin call and the position is closed out if it is not funded quickly.
The nuance that catches people out is the size of the leverage. A margin requirement of around 5% means a 5% adverse move in the index can wipe out the entire deposit, which is why position sizing matters more here than in ordinary share dealing.
In practice
Real-world examples.
Example
A pension fund expects a difficult month for equities but does not want to sell holdings and trigger dealing costs. It sells index futures covering roughly 40% of its equity exposure and buys them back three weeks later.
Example
A treasury team at a listed company holds shares received from an acquisition that it cannot sell for six months. It hedges part of the market risk with index futures so that a general market fall does not swallow the value it is waiting to realise.
Example
An asset manager receives a $50 million inflow late on a Friday and cannot buy the underlying shares until Monday. It buys index futures immediately so the money is exposed to the market straight away, then sells them as the shares are purchased.
Formula
Calculation
Notional value = Index level x Contract multiplier, and Profit or loss = (Exit level - Entry level) x Multiplier x Number of contracts.
Suppose the index is at 4,800 and the contract multiplier is $50. Notional value of one contract = 4,800 x $50 = $240,000. The exchange requires initial margin of $12,000 per contract, which is 5% of the notional value.
A trader buys two contracts and the index rises to 4,860 before they close the position. Profit = (4,860 - 4,800) x $50 x 2 = 60 x $50 x 2 = $6,000. On margin of $24,000 that is a 25% return from a 1.25% move in the index. Had the index instead fallen to 4,740, the loss would have been the same $6,000, cutting the margin balance to $18,000.Case study
Seen in the real world.
Cavendish Grove Asset Management is a fictional boutique manager created for this illustrative case. Ahead of a major economic announcement, its investment committee wanted to reduce equity exposure on a $60 million portfolio for two weeks without selling the underlying holdings.
With the index at 5,000 and a multiplier of $50, each contract covered $250,000, so hedging half the portfolio required 120 contracts. The index fell 4% over the fortnight, and the futures position gained roughly $1.2 million against a portfolio loss of about $2.4 million.
The committee's own review noted the cost of the insurance. Had the market risen 4% instead, the same hedge would have given back $1.2 million of gains, which is the trade every hedger accepts when they buy protection.
Watch out
Common mistakes.
- Sizing a position by the margin posted rather than by the notional value, which leads people to take far more market risk than they intended.
- Forgetting that index futures must be rolled before expiry, so a long-term hedge involves repeated transactions and a rolling cost each quarter.
- Assuming the futures price should equal the index. It normally sits slightly above or below because of financing costs and expected dividends.
Questions
People also ask.
Do index futures pay dividends?
No, and that is precisely why the futures price is adjusted downwards for the dividends a holder of the shares would have received.
What happens if the position is still open at expiry?
It settles in cash against the official settlement level of the index, and the resulting profit or loss is credited to the account.
Are index futures only for speculators?
No, hedging is arguably their main use, with pension funds and corporate treasuries among the largest users of the contracts.
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