If you've ever listened to an early morning financial news broadcast, you've heard a reference to "futures" and how they affect the stock market before it opens. Investors follow the futures because it provides an indication of where stocks are headed at the opening bell. One of the most widely followed futures is the Dow Futures, whose underlying value is based on the Dow Jones Industrial Average, an index of 30 major U.S. companies.
The Dow Future is a contract which is based on 30 specific stocks. Investors in Dow Futures make money when the DJIA declines.
The Basics of Futures
Before getting into the Dow Futures, it is important to understand the definition of a future. A future can generally be defined as a contract which stipulates the buying or selling of a specified commodity for a certain price at a specific point of time in the future. There are futures contracts based on oil, corn and currencies and more.
Futures trade on a futures exchange like the Chicago Board of Trade. You don't have to own the actual commodity to enter into a futures contract. For example, you can sell a corn future without having to store or deliver bushels of corn to the contract buyer.
Dow Futures Contracts
A Dow Future is a contract based on the widely followed Dow Jones Industrial Average. There are 30 stocks that make up the DJIA. The value of one Dow Future contract is 10 times the value of the DJIA. For example, if the DJIA is trading at 12,000, the price of one Dow Future is $120,000. If the DJIA rises by one point, the value of a Dow Future will increase by $10. A futures buyer makes money when the DJIA rises.
The seller makes money if the DJIA declines. Let's say the DJIA rises from 12,000 to 12,065. The futures buyer receives a deposit in his brokerage account of $650 from the seller. If instead of rising, the DJIA fell from 12,000 to 11,984, the futures buyer would settle the transaction by paying the futures seller $160.
The Impact of Dow Futures
Dow Futures begin trading on the Chicago Board of Trade at 7:20 a.m. Central Time. Because the Dow Futures trade a full hour and ten minutes before the stock market opens, the investment community and financial reporters get a sense of the general market sentiment. If the Dow Futures are trading lower, chances are the stock market will open lower. The opposite is true if the Dow Futures trade higher before the market opens. Traders use this information to take positions in not just the futures market, but also on individual securities.
Risks of Trading
Trading Dow Futures is risky. A leverage factor of 10 is good when it works in your favor. However, you'll owe a lot of money if you're at the wrong end of futures contract. The DJIA fluctuates daily based on a number of unexpected factors, such as geopolitical events, making futures a risky investment. If you're interested in trading futures, your broker is required to give you information regarding the risks of futures and options trading.