At a Glance
- With products that replicate different parts of the equity market, sophisticated investors can manage equity index risk in futures markets
- Micro contracts available for the Dow, Nasdaq, S&P 500 and Russell 2000 marked their first year in May
Closely watched equity indexes like the Dow Jones, Nasdaq and S&P 500 have received plenty of attention in 2020. It’s an appropriate time, then, to review why and how these indexes are traded on futures markets.
When traders and investors use equity index futures and futures options it gives them the tools needed to create positions and investments which, at one time, were only institutional in nature.
With products that replicate different parts of the equity market, small caps, mid-caps, or large caps, many sophisticated individual investors can find exposure or risk management for most portfolios.
Traditionally, the largest institutions use index futures and options for a variety of strategies. Among the more popular trading strategies are index arbitrage, which trades the differential between cash and futures and statistical arbitrage which finds correlation between small baskets of equities that track an index. Both of these strategies are important in keeping the market efficient. When prices start to decouple, arbitrageurs bring them back into line. These positions are fairly dynamic being used during daily trading sessions.
But the most popular strategy in institutional use is the synthetic position using futures and or futures options to replicate positions in the equity world. It is a strategy used by the largest of the university endowments and index funds all the way down to individual investors looking for directional coverage.
Most large institutional strategies involve capital requirements which make it unfeasible for smaller investors. Both index arbitrage and statistical arbitrage require cross margining involving two different regulators. But creating a synthetic position, using listed index products, give experienced smaller investors the ability to manage risk and exposure much like an institution.
With the introduction of the E-Mini and Micro E-Mini S&P 500 contracts, small investors can mimic the movement of the entire market using the liquidity and round the clock trading they find in futures markets. Micro contracts, which marked their first year of trading in May, are also available for the Nasdaq, Dow and Russell 2000 indices.
With the right financial vehicles, keeping risk tolerance and capital requirements in mind, sophisticated investors can replicate institutions by employing the investment and trading strategies which they have used for decades. It’s just one sign of the advancement of equity index futures.
Watch this week’s OpenMarkets Weekly above.