In most financial assets, you can either trade in the spot market or enter into a trade for the future. In simple terms, in a futures contract, two parties enter into a contract to buy or sell an asset at a pre-decided price at a future date. Looking at the stock markets, there are futures contracts on the index as well as individual stocks. How do futures markets work? Why do they exist and what time do they open?
What are futures markets?
Unlike forwards, which are non-standardized off-exchange contracts, futures are standardized contracts readily available on exchanges. Futures are derivative contracts that can mimic the price action of the underlying asset. Instead of buying or selling the asset now, you enter into a contract to buy or sell the asset at a future date. However, by design, the futures contract is a leveraged bet on the underlying asset.
There are a few terms that help explain how the futures markets work.
- Contract size: The contract size is the quantity of the underlying in one contract. For example, the contract size for S&P 500 futures is $250 multiplied by the index future price.
- Expiration date: The expiration date is the last day that a futures contract is tradable. In the U.S., stock and index futures contracts expire on the third Friday of every third month.
- Margin: The margin is the amount you deposit with your broker for the futures contract. The margin is set a percentage of the contract value and changes daily based on the movement in futures prices.
What time do U.S. futures markets open?
According to the CME (Chicago Mercantile Exchange), which owns the electronic futures exchange, trading in futures begins at 5:00 p.m. CT on Sunday and continues until 4:00 p.m. CT on Friday. There is a one-hour break daily starting at 4 p.m. CT. Futures prices closely track the spot price during the hours when markets are open. If the futures price is higher than the spot price, it is known as contango. However, the contract is in backwardation if the futures price is lower than the spot price.
Why do futures markets exist?
Futures markets help bring efficiency to the markets. In some cases, like trading in an index, it is easier to trade in the future than buy all the stocks in the index to replicate the strategy in spot markets. In some industries like commodities, producers can hedge their revenues by trading in futures markets. Also, exporters and importers trade in currency futures to hedge themselves against any sharp or unforeseen negative price movement
Do futures markets predict stock prices?
Futures prices help predict what level the stock or the index will open. For example, after U.S. stock markets close for normal trading, futures still fluctuate. During the normal trading hours, the news flow from the U.S. impacts stocks’ price movement. However, after U.S. stock markets close for the day, futures prices are impacted by news flow elsewhere. Post-market announcements in the U.S. can also impact futures prices.
How stock markets trade in global markets impacts the futures prices for U.S. stocks. Many times, we see stock futures drop if Chinese or European markets fall and vice versa. While futures markets can be a good predictor of stock prices, at times sentiments change as trading resumes in the U.S. In 2020, there have been many instances when the price action in normal trading hours has been very different from the futures markets.