How to Explain Stock Index Futures
- 1). Explain the concept of financial "derivative" so these contracts are understood in their basic terms. It is best to avoid using stock market terminology and simplify examples to the real world. For example, explain how a contract may present between a farmer and a buyer even before the crop season is done. The buyer may negotiate in advance a set price for the delivery of a corn. This contract is binding, no matter what happens to the corn. The contact may require that the farmer deliver 100 bushels of corn for $2 per bushel by October 1. This is a contract for a future delivery date, thus it is a "futures" contract. If the farmer has a plentiful crop with a surplus of supply, the actual value of the corn would be less, and the farmer profits from the pre-set price. If the crop is poor, and demand outweighs supply, the farmer may lose money by selling the corn at much less than its actual value. The futures contract is thus a speculative position for both parties, and either could profit or lose on the transaction.
- 2). Define the concept of a stock market index. Individual stocks are readily understood by many people, as they simply represent partial ownership in a company. An entire stock index is simply an average of the share prices for a large collection of stocks. Usually this average is weighted such that larger companies with greater capitalization have a stronger influence on the stock index number. Many indexes exist, and each represents different collections of stock. The S&P 500 is the largest major index followed in the world. It is comprised of the 500 largest companies in the United States and is considered an effective measure of the overall stock market. By comparison, the Dow Jones Industrial Average uses a much smaller sampling of only 30 companies. When a stock index rises, it indicates the overall success of the companies it follows. Thus one index may outperform another, depending on the collection of stocks it contains.
- 3). Combine the concept of a stock index with that of a futures contract. Unlike tangible goods, such as corn, a futures contract for a stock index cannot result in the actual delivery of an item or shares or stock. An index is a mathematical average only, not an actual stock holding, thus there is nothing from the index that can be delivered. When two parties engage in a futures contract for a stock index, they are both making a prediction on the behavior of the index. The only way to settle such a contract at its deadline, or expiration date, is to distribute cash to the party that correctly predicted the market's direction. Thus all stock index futures are cash settled. The amount of cash that changes hands is in proportion to the actual level of the stock index as it compares to the futures contract. If the market rises considerably, the party that predicted the increase will profit more than if the market had risen only modestly.