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What is a Stock Index Future?

Dale Marshall
Dale Marshall

A stock index future is a form of financial futures contract, which is a standardized contract between two parties to deliver a certain quantity of financial assets, like stocks or currency, on a specific date in the future, called the settlement date. Since a stock index future is a futures contract whose underlying asset is intangible — that is, the value of a particular stock index — settlement is made not by the delivery of the asset, but in cash.

In the United States, commodities futures contracts first appeared in the 1840s, when farmers would contract to sell their harvest for a particular price before actually bringing it to the market, locking in both price and commodity for both parties. The concept of future contracts is much older, though. The Greek philosopher Aristotle tells the tale of Thales, who contracted with olive press owners for their services well in advance of olive pressing season, negotiating low prices for these future services. When the harvest turned out to be very good and demand for olive presses was high, Thales was able to sell the time he'd already purchased to olive growers at a handsome profit.

Businessman with a briefcase
Businessman with a briefcase

The holders of futures contracts don't necessarily expect either to deliver or receive the actual assets underlying the contract. Instead, they'll buy or sell contracts during the period between the contract's inception and the settlement date, hoping to make a profit. For instance, during the first Gulf War in 1991, oil futures prices skyrocketed as soon as it became evident that the oil fields in the region were in jeopardy and production might be adversely affected.

Investing in stock index future contracts is similar, but instead of concerning themselves with the conditions related to the production and delivery of a single commodity, investors expect to make money based on the future performance of stock indexes — groups of stocks traded on the major stock exchanges worldwide.

Investors purchase stock index future contracts for a variety of different reasons, such as the anticipation of profit based on market performance, and as a hedge against other investments. The anticipation of future profit is a straightforward motivation; the investor will expect that the market will go up, but instead of trying to determine which stocks will increase in value, she will invest in an index that reflects the entire market. In other cases, investors may purchase stock index future contracts as a hedge against potential loss in other investments; that is, acknowledging that there's a possibility of loss in one investment, they'll purchase a stock index future contract whose anticipated profit will offset the possible loss. An accepted strategy for minimizing the impact of loss, hedging is nevertheless not an exact science and investors sometimes lose not only in their primary investment, but also in the investment made as a hedge.

Like many other investment opportunities in the financial markets, trading stock index future contracts is complicated and carries with it the potential for significant loss. Consultation with a trusted and knowledgeable financial adviser is always a good idea before making any such investments.

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