Most Stock Traders start their day before the opening bell. They turn to their favorite information source online or on TV to check the Stock Index futures.
Namely, DOW, NASDAQ, and S&P 500 futures. They use the futures levels as a guide to how stocks the direction of stock market during the regular trading session.
But, what are futures?
Futures are tradable financial instruments that are derived from another underlying financial instrument.
An example would help.
Let us look at Crude Oil. Crude Oil can be traded in Spot or Futures market.
When you trade in the Spot market, you are buying the ‘physical commodity’ Crude Oil at the current price. You pay the seller, and take delivery of the product – much like you and I would when we buy gas at the pump.
When you trade Crude Oil in the futures market, you buy or sell contracts on Crude oil to take future delivery (when buying) or to make future delivery (when selling).
Contracts traded on exchanges are standardized to increase liquidity, so the contracts are set to expire following a well known schedule.
For example, you may trade June 2010 Futures Contracts in Crude Oil – these would be due for delivery on July 14, 2010.
Futures can be traded 24 hours a day, for five and half days a week.
Future contracts on Crude Oil allow airlines to buy fuel for future delivery for a known price — the price they paid when buying the futures contract. This allows them to ensure they have fuel for their operations, and gives them control over their cashflow.
They can, if they choose, buy up additional contracts if they expect fuel to be more expensive in the future, and make profits trading the futures contracts.
So, what are Stock Index Futures?
They are contracts that can traded just like Crude Oil Futures contracts, except the underlying instrument is a Stock Index.
If you are bullish on DOW Stocks, you buy DOW Index Futures Contracts (say June 2010) today, expecting that the underlying DOW Index goes up before July 16, 2010, you can sell the Futures Contract you bought for a higher price.
Since you can not buy a stock index, you can use it’s futures contract to trade your opinion about the Indexes future direction and level.
Experience traders can use to positions in Futures Contracts as hedge against their stock portfolio.
The value of DOW Futures is directly related to the value of DOW Jones Industrial Average. Since DOW Futures can be traded 24 hours a day, and are also traded when Stock Exchange are closed, the price of Futures Contract can get ‘away’ from the level of the DOW Jones Industrial Average.
Every morning, a stock trader would look to see how much the DOW Futures have moved away from the previous closing level of DOW Jones Industrial Average – up or down – to predict where the DOW Jones Industrial Average is likely to open.
But, it is important to note that, even when the Stock Market is open for trading, the DOW Jones Futures can diverge from DOW Jones Industrial Average.
In subsequent posts, we will examine how a stock trader can use this information to guide their trading during the day.
