A discussion on trading index futures’ important advantages over trading the portfolio of shares corresponding to the index – Dr. Gene Benter

Introduction:

Big business people in financial arena talk a lot about trade index, index futures, trading

index futures as well as trading portfolio of shares. A beginner must have been groping in the

dark every time there is invitation to invest on some index products. It is easy to imagine the

puzzling look on their eyes. What exactly are these people talking about?” On this paper, the

focus lies on the important advantages of trading index future over trading the portfolio of shares

that match up with the index. The objective is assimilating the various effort of our beloved

professor for us to understand these two important concepts in the financial landscape. In the last

analysis this discussion paper is purely a theoretical presentation of trading index futures.

According to Christos Floros and Dimitrios V. Vougas (2007) researchers of index

futures normally demonstrate that “futures returns lead spot returns, while futures market has a

stronger lead effect”. They also cited that when “a bi-directional causality exists between the two

series, then spot and futures have an important discovery role. Hence, an electronic market may

enhance price discovery. The discovery of one price will definitely provide valuable information

about the other (p.168). It is therefore suggesting that the trading in the index futures needed to

be looked closely and decided immediately once movements in the price ceiling occur.

Between options and futures, the significant difference lies on the fact that options give

the owner the right to buy or sell the asset at expiration, while the holder of a futures contract is

obligated to complete the terms of the contract.

Stocks that are extremely versatile securities are called options and they can be used in

various transactions in futures. Oftentimes, Traders in futures make use of options to do a

relatively risky practice of speculation while traders who are familiar with hedgers use options to

minimize if not totally erase the risk involved of holding assets.

This discussion paper does not claim authority on the subject matter but it expects to be

precise and correct for the sake of those who are not fully oriented about the concepts and

processes in the trading index future. The style of this paper is analytical and qualitative since

some people were interviewed to seek their expert opinion on this matter and ideas from

literatures about the underlying subject matter were cited.

Trading index futures

Index futures are simply understood as a futures contract on a stock or financial index.

According to Hill (2007) index futures falls under a financial contract that requires a certain

investor to acquire an asset or a particular seller to trade an asset at a preset future date and price.

These assets may include physical commodities, financial instruments, securities which are

usually negotiable certificates of deposit (CDs), bankers’ acceptances, US treasury bills,

commercial papers, municipal notes, federal funds, and repurchase agreements (repos).

Furthermore, the concept of futures contract, from the reflection of Terpstra & Sarathy (2000)

specifies the quality and quantity of the principal assets which are regulated to make possible the

trading on future exchanges. The futures contract could secure for physical delivery of the asset

while some holders settled for the cash equivalent. This why, according to Hill (2007) futures

markets are different, in the sense that it has the capability to use very high leverage. On this

sense, index futures are relative to stock markets.

Ordinarily, futures are applicable either to hedge or to speculate when there is movement

on the price of the asset. Let us say, I am a producer of peanut butter. I could use futures to lock

in a certain price and hedge. But, other investor or buyer could make speculation regarding the

price movement of peanut butter by using the long or short futures. In this sense, anybody can

participate even in the side street market movement using one trading decision or not worrying

what individual assets to chose. In the study of Minho Kim, Andrew Szamary and Thomas

Schmarz (1999), they describe the correlations of stock index futures and options contracts

following the price movement of their respective indexes. The same observation was illustrated

by Gulen and Mayhew (2000) and they claimed that stock index futures and option contracts are

popular among financial professions and individual investors to protect their portfolio and to

secure investment reward later. It led to the conclusion according to Martin Weber and Colin F.

Camererb (1997) that it is easier to invest in index products than buying and selling stocks. The

presence of the stock index futures and options on future, exposures to these markets can be done

more efficiently and cheaply.

Advantages of trading index futures

There is Lower Margins but with Greater Leverage

According to the analysis of Joel Peress (2004) there is lower stock margin for stocks

exchange in the index contracts in terms of percentage of contract value when viewed within the

trading portfolio of shares corresponding to the index. Added to this is the higher leverage

providing greater exposure to price changes and allows taking larger positions in these contracts.

For example, if I bought the stocks outright in the Dow Jones Industrial Average, the

most leverage available is 50%. If the DJIA were at $9,000, I would need about $45,000 to

participate in the basket of stocks in the DJIA compared to the $5,400 needed to participate in

the same stocks with a futures contract. Because the money I call is not needed immediately I

could make assumptions and hedges to gain higher income.

However, a cautioned was suggested by Robert Almgren and Neil Chriss (1999) with

regard to the execution of portfolio transaction as inferior to trading future index. They cited one

example in trading a highly illiquid volatile security. There are two extreme strategies involved

in this extreme scenario. Trade everything now at a given high cost value or trade in equal sized

packets over a fixed time at relatively lower cost. The latter strategy has a lower expected cost

but this comes at the expense of greater uncertainty in normal revenue. The action to be taken

now is to evaluate this uncertainty as partly subjective and a function of the trader’s tolerance for

risk. This is the best time to prove that for a given level of uncertainty, there is the possibility to

minimize the cost. And simply because of a relatively small amount of margin, even a small

amount of money will be able to control a large amount of capital represented in a stock index

contract or even a small change in the index level might produce a profitable return on the

investment if it is right about the market’s direction.

Let us say, with the Standard & Poor 500 Index at 1150, the value of an S&P futures

contract ($250 times the index) is $287,500, but requires an initial margin of only approximately

$20,000, or about 6.9% of the value of the contract. It is not unusual to have daily swings of 20

points (or $5,000) in S&P futures. If you happen to catch the whole move correctly, that’s about

a 25% return on your margin in one day (Waldock, 2009, p. 3).

It is has Deep, Constant, and Growing Liquidity

In this type of trading we can see the volume and open interest in the stock indexes as it continue

to grow. Through the monitoring system, we can check and validate our assumptions through the

indication of the growing liquidity and strength of these contracts. Based on the investigations of

Christos Floros (2007) he presented that in the price – open interest relation for stock index

futures, there is daily reporting of the open interest position whereby traders can see if there are

increases or decreases in the quantity of contracts that qualified for trading on each particular

period.

Floros (2007) also reiterated that the consistent observing, watching and checking of the

progress each day in the open interest figures, the possibility of arriving at some conclusions at

the end of the trading sessions could be established right away. When there is an increase in open

interest, it suggests that money flows into the market coming from new traders. In the declining

open interest there is a great possibility that the market is liquidating or replenishing its supply of

money. It only means that the current price trend is closing and would soon end. It can be

concluded that this characteristics of trading index futures are beneficial and advantageous to

traders to protect their money before the next movement in the market price.

Availability of Multiple Trading Strategies

Stock index futures are easy to use whether traders are bullish or bearish. Shorting stock

index futures can be easily executed if the investor is not subject to uptick rules, fees, or loans for

short-selling as in the case with stocks. There is always the possibility to use the contract for

outright speculative gain or to hedge all or part of the investment portfolio. Hedging is a strategy

applied to minimize the risk of losing the money. Other financial analysts like Ederington

(1979), Howard and D’Antonio (1984), Pennings and Meulenberg (1997), Floros and Vougas

(2006) treat hedging as a strategy in trade futures to lessen risk. Though they may have different

ideas on its effectiveness, but the mere fact that there is a strategy to hedge the traded stocks

index futures can be remedied when the expected outcome did not turn out favorable.

In the literature review of Floros and Vougas, they came up with “an early measure of

hedge effectiveness which was introduced by Markowitz (1959). Markowitz measures hedging

effectiveness in accordance to the reduction of the standard deviation of portfolio returns

associated with a hedge. In this case, the greater is the reduction in risk, the greater is the

hedging effectiveness” (Floros, et al., 2006, p. 8).

Ease of Tracking

Unlike the older times, stock trading monitoring was done inside the trading rooms and

traders haggle with each other to get a good call or put. At present understanding price changes

in the stock indexes is simple because they are contained in a well-known, often referenced

companies in the advertising section of the print media. The indexes are price-weighted, which

means that a dollar change in any of these stocks will have an equal effect on the index. Quotes

on stock index futures are available online or by calling the broker.

On October 2008, according to the report on the BBC trade index futures, stock index

futures based on blue-chip stocks in the Dow Jones Industrial Average stood at $7,757 during the

entire trading session. The margin for DJIA futures is about $4,000 per contract. It is not likely

that traders would trade three contracts with this size account, but for purposes of showing return

on investment, let us assume that we are going to buy three DJIA futures contracts with $12,000.

The Dow Jones Industrial Average rallies to about $9,265 by December 31 2008, a gain of 1,508

points per contract or 4,524 points altogether. At $10 per point, the account stands at $45,240, a

gain of $33,240 commissions are not included here, or a return of more than 250% on the

original $12,000 margin Stock index futures add elasticity to the portfolio in several ways (BBC

Trade index, 2009, p. 4 – 5).

The Lind Waldock Trading Watch (2009) reported that futures are already be accessible

on different pages of leading stock indexes such as the S&P 500 or DJIASM, on more

technology-oriented indexes such as the Nasdaq-100, on broad indexes such as the Russell 2000,

on international stock market indexes such as Japan’s Nikkei or the U.K.’s FTSE-100 stock

market indexes. Modern technology nowadays has made it virtually possible that there is stock

market exposure and available stock index contract to show or take advantage of it.

Stock index futures are already available and suited to almost any type and size of

account. The S&P 500 for example may register a margin of $40,000 or higher, buyers can still

trade the smaller E-mini S&P or DJIA futures for about one-fifth the amount. These margin

requirements can change as the markets moved that is why the need to close monitoring of the

daily turn out of buyers and sellers is an advantage.

Most major stock index futures have offering options on the futures contract and

increasing available strategies to apply on almost any type of market condition. Traders then

should remember that stock index futures and options are short-term trading vehicles with a time

limitation therefore these are not buy-and-hold investments that can be left unattended.

While the Dow, S&P, and NASDAQ trade on the open auction platform during regular

trading hours, they also trade electronically overnight. The mini-sized contracts are fully

electronic and trade almost 24/7 just to accommodate tracking and monitoring. This type of

electronic platform provides a level of easy access and tracking not only for new accounts but

also for old and nearing maturity futures. The disadvantage of this kind of open auction platform

is the orders are executed anonymously and on a first-in, first-out basis - no preference is given

to market makers.

Conclusion

Having already pointed out some major advantages of futures trading index, it can be

wrapped up into simple languages that can convey what futures trading index and trading the

portfolio of shares corresponding to the index actually operate. Generally, futures are temporary

agreement for transactions or contract involving money that is to complete a maturity period.

The concept of futures is designed for investors who hold sum of money and hope to earn more

in the stock market.

However, putting money in futures is not simply buying a share from a stock portfolio

but a consistent monitoring and immediate strategic action is required to avoid the risk of losing

the invested amount or a shifting from the expected return of investment calculation. Index

futures can give quick exposure to the stock market and allows time to decide what to do on a

more permanent basis. In the last analysis, index futures are meant to be short-term positions and

not for a long term holding strategy.

Bibliography

Almgren, R. and Chriss, N (1999) Optimal Execution of Portfolio Transaction” Unpublished Report, University of Chicago, pp. 7 - 8

BBC, (2009) The Lind Waldock Trading Watch, News and Market edition, October, p, 3

Christos F. and Vougas D. (2006) “Hedging Effectiveness in Greek Stock IndexFutures Market, 1999-2001” International Research Journal of Finance and Economics, Issue 5 Euro Journals Publishing, Inc. . 8 – 9

Christos. and Dimitrios V. (2007) “Lead-Lag Relationship between Futures and Spot Markets in Greece: 1999 – 2001”, International Research Journal of Finance and Economics, Issue 7, EuroJournals Publishing, Inc. p 20

Christos, F. (2007) “Price and Open Interest in Greek Stock Index Futures Market”, University of Portsmouth, SAGE Publication, pp. 191 - 192

Ederington, L. H. (1979), the hedging performance of the new futures markets, Journal ofFinance, No. 34, pp. 157-170.

Howard, C., and D’Antonio, L. (1984), A risk-return measure of hedging effectiveness, Journalof Financial and Quantitative Analysis, No. 19, pp. 101-111.

Huseyin G. and Stewart, M. (2000) “Stock Index Futures Trading and Volatility in International Equity Markets”, The Journal of Futures Markets, Vol. 20, No. 7, John Wiley & Sons, Inc.pp. 661–685

Hill, C. (2007) International Business. 6th Edition, McGraw – Hill Companies, Inc. USA.

Kim, M, S. $ Schwarz, T. (1999) “Trading Costs and Price Discovery across Stock Index Futures and Cash Market, The Journal of Futures Markets, Vol. 19, No. 4, 475–498 John Wiley & Sons, Inc. pp.475 - 476

Markowitz, H. M. (1959), Portfolio selection: efficient diversification of investments, JohnWiley and Sons, Inc., New York

Pennings, J. M. E., and Meulenberg, M. T. G. (1997), Hedging efficiency: a futures exchangemanagement approach, Journal of Futures Markets, No. 17, pp 599-615.

Peress, J. (2003) “Wealth and Acquisiiton, and Portfolio Choice” The Review of Financial Studues, Vopl. 17, No. 3

Terpstra, V & Sarathy R. (2000) International Marketing, 8th Edition, The Hyden Press, Harcourt College Publishers, USA.

http://www.investopedia.com/money_market (access April 30, 2009)

Appendices

Sector Weightings of the Major U.S. Stock Markets

Sector DJIA S&P Nasdaq 100

Industrial 25.5 11.3 1.9

Consumer Non-Cyclical 15.6 9.8 19.1

Consumer Cyclical 14.1 13.6 10.0

Technology 13.7 14.3 48.4

Health Care 9.3 14.9 0.0

Basic Materials 8.0 2.6 0.5

Financials 7.8 20.7 0.0

Telecom 3.2 4.4 20.1

Energy 2.8 5.8 0.0

Utilities 0.0 2.6 0.0

The Dow

CBOT® Dow Futures Overview

Contract Dow Futures E-Mini $5 Dow Futures

SymbolOpen Outcry: DJElectronic: ZD

YM

Contract Value

$10 x DJIA futures price - e.g. $80,000 if DJIA futures price = 8,000

$5 x DJIA futures price - e.g. $40,000 if DJIA futures price = 8,000

Contract Months Mar, Jun, Sep, Dec Mar, Jun, Sep, Dec

Minimum Fluctuation 1 index point = $10 1 index point = $5

Hours (CTS)

Open Auction:7:20am - 3:15pm Mon - FriElectronic:8:15pm - 7:00am Sun - Fri

Electronic:8:15pm - 4:00pm Sun - Fri

Source: CBOT, Contract specifications subject to change without notice. 

 

S&P 500

S&P 500 Futures Overview

Contract S&P Futures E-Mini S&P

Symbol SP ES

Contract Value

$250 x S&P futures price: e.g. $225,000 if S&P futures price = 900

$50 x S&P futures price: e.g. $45,000 if S&P futures price = 900

Contract Months Mar, Jun, Sep, Dec Mar, Jun, Sep, Dec

Minimum Fluctuation 10 index points = $25 25 index poinst = $12.50

Hours (CTS)

Open Auction:8:30am - 3:15pm Mon - FriGLOBEX:3:45pm - 8:15am Sun - Fri

Electronic:5:30pm - 3:15pm Sun - Fri

Source: CME, Contract specifications subject to change without notice. 

 

NASDAQ 100

NASDAQ 100 Futures Overview

Contract NASDAQ Futures E-Mini NASDAQ

Symbol ND NQ

Contract Value$100 x ND futures price -e.g. $120,000 if NDfutures price = 1200

$20 x ND futures price -e.g. $24,000 if ND futures price = 1200

Contract Months Mar, Jun, Sep, Dec Mar, Jun, Sep, Dec

Minimum Fluctuation 0.50 index points = $50 50 index poinst = $10

Hours (CTS)

Open Auction:8:30am - 3:15pm Mon - FriGLOBEX:3:45pm - 8:15am Sun - Fri

Electronic:5:30pm - 3:15pm Sun - Fri

Source: CME, Contract specifications subject to change without notice.

Investopedia explains Option

In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.

For example, because the option writer will need to provide the underlying shares in the event that the stock's market price will exceed the strike, an option writer that sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option, as that is how he or she will reap maximum profit.

This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise, because if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit.

most stock index futurestrades can be accomplished quickly and efficiently. Notevery stock index futures market has sufficient liquidityto allow easy entry and exit with minimum slippage, butmarkets such as S&P 500 futures can handle almost anysize order at any time during the trading session. With

78electronic trading in contracts such as the E-mini S&P500, trading sessions are now stretching almost aroundthe clock.Many mutual funds require investors to wait until theend of the day to see at what price they were able topurchase or sell shares. With today’s volatility, once-adaypricing may not give you the maneuverability totake positions at exactly the time you want. Stock indexfutures give you the opportunity to get into or out of aposition whenever you want and often within seconds of

receiving your order

Index Option

What Does Index Option Mean?A call or put option on a financial index.

Investopedia explains Index OptionInvestors trading index options are essentially betting on the overall movement of the stock market as represented by a basket of stocks.  Options on the S&P 500 are some of the most actively traded options in the world.

Why now is the perfect time to invest...

*** The first share for our Dummy Portfolio...

*** The cold hard truth about investing… and more...

Dear Investment Academy reader,

We all know that the markets took a nosedive in 2008. Those who were heavily invested took a pretty bad knock and new investors are now afraid to take the next step and invest in their first shares.

This is exactly what I want to talk to you about today. Why investing NOW can produce excellent long-term gains.

My plan for the year is to select a few shares that I think will do well in 2009. Each week I’ll update the share prices from the date we selected it and you can see how well or badly the share’s performing.

I’m going to discuss two shares today. One, I’m placing on our watch list and the other I’m placing in our new “Investment Academy Dummy Portfolio”.

We’ll track the performance of these shares in the “Dummy Portfolio” throughout the year and hopefully put your investment fears to rest.

Before we continue, I’d like to highlight something upfront. I’m NOT recommending that you run out and buy these shares. This portfolio is for demonstration purposes only. What I want to prove is that, even in an unstable market, there are shares that present excellent growth for 2009. But we'll have to wait and see how we get on.

Let’s get straight into it…

Here’s the cold, hard truth

There’s no doubt in my mind, the JSE’s going to have an extremely difficult time recovering in 2009. According to BOE Private Clients’ investment research team, the economy’s only going to grow between 1% and 2% this year.

But, as we approach 2010 and the FIFA Soccer World Cup, I’m confident that our local market is going to flourish again. This is one of the main reasons why you should be looking for good quality shares at their current low prices. They’re perfect for a three to five year (long-term) investment strategy.

Many good quality shares are finally affordable!

Let’s take Sasol (SOL) as an example:

Source: Sharefriend

This graph (above) shows you the movement in Sasol's share price since 7 January 2008. Sasol was trading at around R360 at that time. The share price climbed drastically and peaked above the R550 mark in May 2008.

Most global markets were already falling. But the problems only hit us when commodity prices started tanking. The local markets began to feel the pain and the share price went into a downward spiral. Today, Sasol’s trading at R278.00. That’s even cheaper than it was at the beginning of 2008!

But is that enough to make Sasol a good investment for 2009?

The first thing we need to look at is the news. Sasol’s been hit with another price fixing scandal. That’s the second scandal in less then eight months. (First it was the wax cartel issue and now it’s a gas issue.)

We could see the share price fall even lower, but it’ll never stay down there forever. I’m going to keep my eye on this share in 2009. I wouldn’t add it to the “Dummy Portfolio” right now, not with all the problems relating to the competition commission looming over its head.

But, I’ll follow the share price and the share very closely and wait for the perfect time to add it to our “Dummy Portfolio”. Sasol's also linked to the oil price. There are rumours that the fuel price will be rising again next week. But, there’s nothing wrong with waiting before making that crucial buy.

So what should you do now?

There are many shares like this on the market at the moment, offering value not seen in years. You just need to keep your ear to the ground and get your timing as right as possible.

Here’s an example of a great share that seems to have everything poised for a good year in 2009.

Anglo American (AGL) - A solid blue chip for the “Dummy Portfolio”

Source: Sharefriend

Take a look at the graph of Anglo American above. This share was doing really well until the markets started diving in 2008. It’s currently trading at R190.00 - that’s 65.89% off its 12 month high of R557.00. It’s currently on a PE of 5.09.

The management of the company can be proud. They’ve dropped capital expenditure for 2009. It’s been capped at $4.5 billion, a reduction of more than 50%. This massive drop means there will be a drive to stop unnecessary spending in the current market conditions and focus on the projects that’ll bring in the best production for 2009.

“Anglo American is well positioned to weather the current weak economic conditions and to continue to prosper for the benefit of all our stakeholders."    - Cynthia Carroll, Chief Executive of Anglo American

This is a quality share, at an affordable price. And I’d like to test drive it for the year. I’m going to add this to our Dummy Portfolio for 2009. Once the markets settles down, this share should rebound nicely. It’s already following a strong upward trend and I hope to see more throughout the year.

Let’s make 2009 a year of communication

That’s it from me for today… But before I sign off, just two more things:

1. Remember, this is a hypothetical portfolio and I do NOT advise you to buy any of these shares,2. Let’s make the “Investment Academy Dummy Portfolio” a team effort. If you have a share that you think is going to be a stellar performer this year, send me your reasons for this selection to iacomment@fsp.co.za. If it’s a good one I’ll add it to the portfolio.