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S&P futures lead the way
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May 1, 1999: 6:44 p.m. ET
Though complex, the most-traded of stock-index futures forecasts the market
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NEW YORK (CNNfn) - Around the world, around the clock, billions of dollars move in and out of one of the most abstract financial tools ever designed: the S&P 500 futures contract.
Buying or selling the contract -- the most actively traded among stock index futures -- is like making a bet.
In this case, it's a bet on the direction of the S&P 500 index, a broad measure of stock-market changes based on the performance of 500 large companies' shares.
The contract's purchase or sale is a legally binding agreement to buy or sell a derivative of the S&P 500 index at a preset price on a preset date.
But if S&P 500 futures are complex, their use as a stock-market forecasting tool remains clear.
Like the S&P 500 index itself, the underlying value of an S&P 500 contract -- whose underlying index represents 80 percent of the value of all stocks on the New York Stock Exchange -- rises and falls based on what traders will pay for it moment to moment.
And because the contract's terms are settled at a future date, an S&P 500 contract's price generally leads the S&P 500 index it's derived from -- on both the upside and the downside.
"The futures give an indication where stocks are likely to go," said Hans Stoll, a Vanderbilt University finance professor who has studied the contract. "The futures lead the cash."
As such, an S&P futures quote is to short-term market forecasts what the satellite photo is to weather predictions.
In a study, Stoll found that during the trading day, the futures index leads the regular index by an average of five minutes. Before the opening bell, a similar but less predictable relationship exists.
"It's a useful early indicator of where the hot money is going to go that day," said Jeff Davis division chief investment officer of State Street Global Advisors.
Typically, 1 point on the futures index equals 8 points on the Dow Jones industrial average as trading begins. This 1-to-8 relationship reflects the ratio between the value of the S&P 500 index, recently at 1,363, and the Dow average, at about 10,700.
Hedgers, speculators
Launched in 1982 by the Chicago Mercantile Exchange, the S&P 500 futures contract is part of a long history of futures dating to the 19th century.
Like pork-belly or U.S. Treasury-bond futures, stock-index contracts exist for some to manage risk and for others to speculate in the markets.
A money manager who owns stock in S&P 500 companies, for example, might agree to sell the contract at a preset future price.
This way, if the price of the stock portfolio falls, the manager can guarantee the drop will be offset by the contract's sale.
If the portfolio strengthens, the money manager would buy an offsetting contract, neutralizing the original position but taking a loss with the rising futures price.
For every contract bought or sold, there exists an offsetting seller or buyer.
These investors are often speculators who move in and out of the contracts, making or losing money based on the accuracy of their bets.
When dealing with S&P 500 futures, the future is rarely far away.
The S&P contracts expire in March, June, September and December, with the most active trading done in the near-month contract.
At any given period, an investor can offset the contract by taking the opposite position, either receiving a gain or loss based on current market prices.
If the contract is held to expiration, the investor is subject to a cash settlement against the contract's price.
Barriers to entry
Because of the huge cost, the futures game is mostly played by big financial institutions like investment banks and mutual-fund companies.
The price of an S&P contract equals $250 multiplied by the S&P 500 index's current level, making one S&P 500 futures agreement currently worth about $339,000, based on recent closing prices.
A movement of 1 point in the contract equals $250.
Buyers and sellers of S&P futures come together electronically and across continents from 4:45 p.m. to 9:15 a.m. ET on the Globex trading system, and through open outcry trading from 9:30 a.m. to 4:15 p.m. ET at the Chicago Mercantile Exchange.
The futures pits, Chicago Mercantile Exchange
As volume grows, the contracts keep coming.
After creating the S&P 500 contract, the CME has gone on to design eight stock-index futures. These include those based on the Nasdaq and Russell 2000 indexes, as well as two derived from Japanese and Mexican stock indexes.
The Chicago Board of Trade, meanwhile, began listing a Dow Jones industrial average futures contract in 1997.
But of all the stock-index futures, the S&P 500 changes hands the most, averaging 111,375 contracts in daily volume this year.
"Open interest," or the number of open positions in the June near-month contract, totaled 382,689 as of this week, or $1.2 trillion in market value.
The rise in the contract's use, State Street's Davis said, has much to do with its breadth and liquidity, or the ease of pairing buyers and sellers.
"It's the fastest and easiest way to get in and out of the markets," he said.
But the contract's growth, Davis said, is also related to a rising need among financial institutions to manage risk at a time when price-to-earnings ratios of many S&P 500 stocks are at historic highs.
With so many money managers hedging against a downturn, the S&P futures may lead the market in more ways than one.
-- by staff writer Jake Ulick
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