Equity Futures Contract

A financial transaction between two entities to acquire or sell equity at a predetermined date, amount, and price

An equity futures contract is a financial transaction between two entities to acquire or sell equity at a predetermined date, amount, and price. The buyer must purchase these shares at the expiration time, and the seller is obligated to furnish these underlying shares.

Equity futures allow investors to bet on the future price of a particular stock, with buyers and sellers attempting to arbitrage to realize their assumptions about the store. 

If the value of the underlying share rises in the future, an equity buyer of a futures contract would typically benefit, and vice versa, from a profit loss.

On the other hand, a seller will profit if the value of the underlying shares falls at the future expiry date and a loss if the value rises. As a result, buyers and sellers have conflicting intents in an equity futures transaction.

These are traded on the derivatives exchange for speculative and hedging purposes. Index futures and stock futures are the most frequent types of futures contracts.

How does equity futures work? 

In contrast to other financial instruments, such as stocks, the buyer and seller are not usually required to pay the whole amount of cash upfront for the underlying asset.

Instead, an initial deposit margin will be required to open an equity futures position. The margin will be calculated in percentages and will vary depending on the contract value.

To calculate the value of an equity futures contract, multiply the underlying stock price by the contract size. The number of underlying shares given in each contract determines the contract size. Typically, one contract has 100 underlying shares.

Other variables to consider when evaluating equities futures contracts include the features and risks of the product of interest. These are included in the Key Information Document (KID). The risk category will also decide the margins that must be placed to enter the futures contract.

Because a fraction of the contract's value is displayed first, stock futures contracts are highly leveraged. 

Any price shift might substantially alter the risk and return on a future position. As a result, when the margin requirement is significant, an investor will often have to deposit more to start an equity futures position. This reduces the investor's leverage.

Futures contracts also entail a minimum price increment, known as the 'tick price,' which indicates how much fluctuation there is for the particular contract. Another term often associated with futures contracts is tick value, which is the monetary amount gained or lost per contract per tick move (tick size x contract size). 

What must be included in an equity futures contract? 

  1. Underlying equity: This must specify the nature of the transaction-indexes such as the S&P 500, for example, or individual stocks. 
  2. Specified date: This determines whether the date is the expiry date or the settlement date. The cash flows will be resolved, and the ultimate profit/loss will be realized on the stipulated date.
  3. A specified amount establishes the price at which the underlying stock must be traded.
  4. Margin: The amount put aside by each party to enter the positions during the contract. The margins reduce the danger of the opposing party terminating the contract.

How and when are they settled? 

Equities futures contracts are settled daily distinguishes them from other financial products. 

The closing market price on the futures exchange is decided at the end of each trading day. The daily market-to-market (MTM) price is another name for this. There are usually daily MTM settlements until the futures contract expires or the position is closed.

The daily settlement price for the front month for most stocks in the Equity Index futures is computed using the volume-weighted average price (VWAP) based on the latest 30 seconds of the trading day.

In the case of the E-Mini NASDAQ-100 futures contract, the average would be based on trading activity on CME Globex between the time of 15:14:30 and 15:15:00. 

The daily settlement will offer traders, brokers, and investors information on managing their daily profit and loss while potentially modifying their margin amounts.

Another type of settlement is known as the final settlement. The value for determining this is known as the Special Opening Quotation (SOP). Again, the index provider determines this, which is usually derived using the opening prices of each underlying stock.

In the S&P 500 futures, the SOQ is calculated by the first traded price for each of the index's 500 company shares. This figure is generated by the Standard and Poors and is typically made accessible on the last Friday of each quarterly futures contract month.

When the equity futures contract expires, there is one more daily settlement before the position is recorded out of the investor's portfolio. This is either cashed or physically settled, depending on the contract. The physical settlement will generally mean the underlying shares are delivered to the receiving party. 

Cash settlement will be computed by subtracting the spot rate of the stock at expiry from the futures price.

Finally, if an investor wishes to leave the contract before its maturity date, the investor may take an opposing position. For example, if the investor had a long post, they would close it by initiating a short work with the same underlying and maturity.

Purpose

Equity futures contracts serve two primary functions: speculation and hedging. Futures are a zero-sum game, meaning there will always be a loser and a winner.

  • Speculating 

Speculators will attempt to forecast the future value of the equity and will utilize a futures contract to secure this price.

For example, if a bullish stock is available, an investor may sign a contract to purchase it in the future. If the guess is correct, the buyer will pay less than the market price for the shares, resulting in a profit gain.

  • Hedging

Hedging is used to mitigate risks and potential losses from investment. For example, an investor may own indexes now but is concerned that their value may fall in the future. 

As a result, they would sign a futures contract to sell the index to hedge against a price decline. If the index loses value in the future, investors will have already locked in a preset price at which it may sell above market value later.

Within hedging, there is long and short hedging. 

1. A long hedge, for example, is when a producer expects a wheat delivery and purchases the wheat now to cover their price risk in the future. This is because the producer anticipates a future 30% increase in wheat prices. 

This formula may be used to calculate the net purchase price:

 Futures price minus basis + broker fees

2. Conversely, short hedging is when a trader sells something initially and then repurchases it later. This is because the trader expects the price of a stock to fall in the future.

  • Arbitrage

Arbitrage is another use for equity futures contracts. Traders profit from unexpected price differences between the futures and underlying cash markets. This is accomplished by simultaneously executing opposing trades in the two marketplaces.

Advantages

  • Low transaction costs: Because the futures contract is based on the value of thousands of shares, stock transaction costs are comparatively low compared to acquiring or selling the total underlying shares. 

In addition, the commission usually is minimal, at 0.5 percent of the contract amount. Internet platforms have also reduced transaction costs.

  • Ease of short selling: A temporary position is simple to initiate, making it simple for investors to profit from an unexpected stock price drop. On the contrary, selling stocks may be more difficult. This is because various markets have various investment laws.
  • Leverage effect: The margin required to open a position in the futures contract is merely a fraction of the underlying stock's value. As a result, hedging and speculative operations may be carried out with lower capital expenditure. 

Trading futures allow investors more exposure to a broader range of equities than owning the original stock.

For example, suppose an investor wishes to invest in Microsoft stocks now valued at $1250. In that case, they may either buy ten stocks immediately or purchase a future contract containing 100 Microsoft stocks (10% of margin for 100 stores = $1250). 

Assuming a $10 increase in the price of Microsoft stocks, the investor would have made a $100 profit if they had invested in the store. However, they would have made a $1000 profit if they had invested in a Microsoft future contract.

  • Lower currency exposure for global investors: Global investors will have less currency exposure since they will only be affected by variations in the margin to carry the position in their native currency.
  • Future markets are more efficient and fair due to the difficulty of trading on insider knowledge in the futures market. 

External influences, such as the next move in Federal Reserve policy, might be challenging to forecast. Moreover, unlike individual equities, where corporate executives may leak information to friends and family, the futures market trades on market averages.

  • The future market is very lucrative: The existence of several buyers and sellers daily makes futures extremely liquid. This means that market orders are placed quickly to capitalize on price differences. 

The futures market also trades after regular stock exchange hours. Extended trading in stock index futures often occurs overnight, with some markets operating 24/7.

Disadvantages

  • No control over future events: As previously said, this is what makes future markets more efficient and fair, but it also implies that there is greater unpredictability. 

Traders, for example, have no control over occurrences such as natural disasters, unforeseen weather conditions, political concerns, and so on, which can radically disrupt supply and demand in the market.

  • Leverage issues: The maximum leverage is usually just 50% when purchasing stocks. Futures trading. On the other hand, it provides substantially more power, ranging from 90% to 95%. This means that futures can be purchased for as little as 10% of the actual value. 

As a result, the leverage doubles the impact of any price adjustments. Thus, minor changes might result in a position liquidation or margin call. The higher the power, the greater the fluctuations in future prices. 

Because of the leverage, it is possible to endure losses more significantly than the initial investment. To deal with the higher power, traders often need to employ improved money management tactics, such as stop-loss orders, which restrict prospective losses.

  • Expiration dates: As the contract's maturity date approaches, the contractual pricing may become less appealing. As a result, some people regard futures contracts that expire as a waste of money. 

Bottom Line 

Many people employ equity futures contracts, and prominent hedge funds such as Blackrock AdvisorsQAR Capital Management, and Bridgewater Associates are popular investing methods. 

The reason for its popularity is that stock futures contracts can lower the chance of sustaining a loss due to an unfavorable shift in the underlying asset market. 

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Researched and authored by Freida Lee | LinkedIn

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