So having looked at the dow jones index, and how it is constructed and maintained, now let’s start to look at the derivative of the index, the dow jones futures index often simply shortened to dow futures, and there are two questions that I need to answer straight away. Firstly, what is a futures contract, and secondly why do we have one on an index, and let me start by answering the second part first.
Why do we have a dow jones futures market?
We are all no doubt familiar with buying and selling stocks and shares, and whenever we do so, real cash changes hands, and we either own or sell a tiny part of the company, with ownership transferring rights to us such as company dividends. We can hold stocks and shares for as long as we choose, and benefit from any increase in the share price as a result. We can trades stocks over a short term basis, for days, weeks or months, or we can buy and hold for the long term, but whatever the strategy, we can speculate or invest in individual stocks or a portfolio of stocks, and whenever we want to sell, then there is always a ready market. Now suppose we wanted to replicate this by holding a basket of all 30 constituent stocks from the dow jones index, would this be possible? The answer of course is yes, but it would be very expensive and extremely unmanageable, and as we will see shortly, would cost around 14 times as much in cash, as opposed to a futures contract which only requires a fraction of the same trading capital in order to allow you, as a speculator, to effectively trade in all 30 stocks, with only a minimal deposit and only one position to manage, rather then thirty. So the answer to the question is simply that a dow jones futures contract allows us to trade all 30 stocks in the index easily, with one trading position, and for a relatively small deposit. There is also one other important reason – a dow jones futures contract can be traded virtually 24 hours a day, whilst stocks on the dow jones index can only be traded when the stock exchange is open.
What is a dow jones futures contract ?
So what is a dow jones futures contract, or perhaps I had better start with the end of the question and answer, what is a futures contract? If you are new to futures trading, then there is one thing you need to have clear in your head from the start. A futures contract is just that, it is a contract between two parties, and as such you have a legal obligation to accept delivery of ( as the contract holder), or deliver to ( as the contract seller ), the underlying asset or commodity. Now as I outlined in my introduction, the dow jones futures contract is a derivative of the dow jones index, and therefore the underlying asset in this case is an index, which cannot be physically delivered, unlike crude oil futures or silver futures for example where buyers do take physical delivery as they need to purchase real goods and commodities for onward supply and manufacturing. The soft commodity futures market is also another where physical delivery often takes place, but in our case we are dealing with an ‘intangible’ asset, an index, which has no physical presence or meaning, and therefore we do never deliver anything physical under the terms of the contract, but simply transfer cash between the two parties involved.
Now futures trading is one of the purest markets, as it is often called a zero sum game, and by that we mean that for every buyer there is a seller, and for every seller there is a buyer. All buyer and sellers are matched equally in the market, so when I lose $1,000 on my contract, the counter party to my trading position who has taken an opposite view to me, gains $1,000. At the centre of this ‘transfer of cash’ sits the exchange, as all dow jones index futures contracts are traded through a central exchange such as the Chicago Mercantile Exchange, which both regulates the market, but also creates the market, ensuring that there is always sufficient liquidity to allow buyers and sellers to be matched at the exchange. Now remember I talked earlier about a futures contract being a contract, and one on which you cannot default, the central exchange has strict rules to ensure that you do not default on any of your obligations, and in order to ensure that these are met, you will be required to put up a sum of money as a bond, a guarantee if you like, as proof of goodwill and good standing. The reason for this is very simple – the exchange guarantees that all market participants will get paid and in return ensures that all trading is conducted in a fair and transparent way, allowing you, as the small speculator to play on a level field with the larger traders and hedge funds, all very different from the manipulated world of forex, where trading is generally conducted directly against the broker, although few traders seem to grasp this basic fact before it is too late. In fact, forex is the perfect example of why you should learn to trade futures, where trading is fair and open, unlike the OTC ( over the counter) world of forex, where prices are rigged, and stops triggered by the fx brokers on a daily basis. However I digress.
So to summarise, a dow jones futures contract is a derivative of the dow jones index, and is a contract between to parties, one who believes the index will rise, and the other who believes the market or index will fall, and as such is traded on a central exchange such as the CME. That seems simple enough, so how do we buy and sell these contracts? Well before we move on the next page, let me just cover one other aspect of dow jones futures trading, and that’s margin or leverage. Leverage is the trading mechanism that allows you to control a large amount of stock with a small amount of capital, and is essentially trading using borrowed money, which comes from your futures broker. All futures contracts are leveraged, so if you want to trade futures, you have to trade using margin, and get to grips with the risks, so let me finish this section with a simple example of how trading on margin works in practice, using a stock which we can generally leverage at 50%, so we pay half and the broker puts up the other half of the money.
- We buy 100 GE stocks at $10 each, and as we are trading using a 50% margin account, we put up $500 and the broker provides the other $500 as margin
- GE moves higher over the next few weeks and is now trading at $15 and so we sell, netting a total of $1500 from the sale.
- We pay our broker back his $500 which we borrowed leaving us with $1000
- The return on our initial stake of $500 is :- ( $1000 – $500 / $500) * 100 = 100% – we have doubled our money!
However, what would have happened if GE stocks had fallen sharply to $5 per stock
- We sell our stock holding, for $500 and pay back our broker the $500 of margin, and we are left with – nothing!!
This is the the power of margin – it has the power to magnify profits but also to accelerate losses and in addition in the above simple example, I have not included the brokers costs for providing you with margin. In the futures market, leverage is even more highly geared, and on a small dow jones futures contract, this is likely to be in the region of 14 to one, where a margin deposit of around $5,500 will allow you to control stocks with a value of approximately $100,000. This is why you need to understand very clearly from the start, what are the risks, and as I stated in my opening remarks, to be successful in trading futures, whether dow jones futures or any others, you must manage your risk – this is the number one rule – risk management. If you can’t face the prospect of taking a loss, then you shouldn’t be trading, and certainly not in the dow jones futures market.
So having covered some of the basics, let’s now start to look at dow jones futures contracts in more detail, to see what they are, how to trade them, and what types are avaialble to us as futures traders in the dow jones futures market.