What is “Equity Futures?”
An Equity Future is a standardized contract that is entered between two counterparties, the two counterparties are agreeing today to trade a specified quantity of a specified stock or index (which is referred to as the underlying asset) at a price fixed today on a fixed future date. This future date will also be agreed upon today and is specified within the contract terms.
Equity futures are traded on an exchange and the contract terms are determined by it (exchange). Equity futures are centrally cleared, where a clearinghouse takes on the counterparty risk of both parties of the initial trade.
Key Learning Points
- There are two key terminologies that one should be aware of with reference to equity futures and that is the long side and the short side of the contract.
- Equity futures are traded on an exchange and the contract terms are determined by the exchange.
- A clearinghouse takes on the counterparty risk of both parties of the initial trade.
Equity Futures – Key Terminologies
There are some key terminologies with regards to equity futures contracts. Firstly, the long side of the contract is the counterparty to the trade that is agreeing to buy the underlying asset – the specified stock/index. Secondly, is the short side of the contract being the counterparty who is agreeing to deliver or sell the underlying asset – the specified stock/index – and receive the pre-agreed fixed price, which is also referred to as the futures price.
The former benefits from an increase in the underlying stock/index, while the latter benefits from a decrease in the underlying stock/index.
Equity Futures – Key Features
The standardization of the futures contract comes from the fact that the exchange on which the futures are traded will be determining those contract terms that include, the quantity of underlying assets per one contract, the underlying asset itself and the future delivery dates. Because of this standardization, there are far more contracts with the same contract terms if we are trading over an exchange using futures.
Next, futures contracts are centrally cleared, which involves a clearinghouse assuming the counterparty risk i.e. it takes on the counterparty risk of both sides of the trade. This ensures that either counterparty would be paid the money that is owed to them under a futures contract, even if the counterparty to the trade defaults on their obligations. The clearing party is assuming that counterparty risk.
To ensure that the clearinghouse does not go bankrupt, because of default by one counterparty to trade – both sides of the trade must pay in a good faith deposit to the clearinghouse when they enter futures trade, this is referred to as the initial margin.
When trading futures contracts, any gains or losses that you make as a result of movements in the futures price are settled on a daily basis. So, any gains that you make from the underlying asset moves in your favour are paid to you daily and any losses that you make because of the futures prices moving against you need to be paid to the clearinghouse daily.
Having entered into an equity futures position, you may wish to exit that position prior to the delivery date within the contract itself. This is possible by entering into another trade with the same underlying asset and the same delivery date as your initial trade but traded in the opposite direction. As a result of these two trades – one which is long, one which is short – both with the same underlying asset and same delivery date, you are left with no overall exposure in terms of calculating any gains or losses.
The way you calculate gains or losses is to look at the movements of the futures price from the initial futures trade and then the secondary closing out futures trade and multiply this by the dollar value of 1 index point that will be specified in the futures contract themselves, and finally multiply this by the number of contracts traded.
In essence, overall gain or loss is calculated using the following formula:
Net gain (loss) from closing out = Change in futures price (index points) * $ value of 1 index point * Number of contracts traded.
Equity Futures – Example
Given below is an example, where we calculate the gain or loss made when closing out the equity futures trade – where the futures contracts traded have been the S&P 500 index futures.
The table below tells us that the S&P 500 index futures price at the inception of these trades was 2,426 index points and this table also shows that the dollar value of 1 index point is $250. What this means is that for every one index point movement in the futures price, there will be a gain or loss suffered to the two counterparties to the futures trade of $250.
Next, we can also see from the table that this particular trader had a long position for the initial trades and they traded 7 futures contracts. At the closeout of this trade, when the trader would have had to sell or be short of 7 futures contracts with the same underlying asset and the same delivery date, the futures price was 2,500 index points.
In terms of calculating the gain or loss, the futures price has increased from the initial trade to the subsequent close out of the trade. The initial trade was for 2,426 points and the futures price went up to 2,500 by closeout – making for this trader a 74-index point gain per contract traded.
Index points cannot be paid and received, so what we need to do is to translate this number of index points into a cash amount and we do that by taking the number of index points this trader has made i.e. 74 and multiplying it by the dollar value of 1 index point which is $250. We need to remember that within this calculation of gain or loss the number of contracts that have been traded – which in this example is 7 and multiply it too to get the overall gain of $129,500.
To conclude, taking all of those points into account this will give the trader an overall gain for these trades of $129,500.