A discussion on trading index futures important advantages over trading the portfolio of shares corresponding to the index Dr.

. Gene Benter

Introduction: Big business people in financial arena talk a lot about trade index, index futures, trading index futures as well as trading portfolio of shares. A beginner must have been groping in the dark every time there is invitation to invest on some index products. It is easy to imagine the puzzling look on their eyes. What exactly are these people talking about? On this paper, the focus lies on the important advantages of trading index future over trading the portfolio of shares that match up with the index. The objective is assimilating the various effort of our beloved professor for us to understand these two important concepts in the financial landscape. In the last analysis this discussion paper is purely a theoretical presentation of trading index futures. According to Christos Floros and Dimitrios V. Vougas (2007) researchers of index futures normally demonstrate that futures returns lead spot returns, while futures market has a stronger lead effect. They also cited that when a bi-directional causality exists between the two series, then spot and futures have an important discovery role. Hence, an electronic market may enhance price discovery. The discovery of one price will definitely provide valuable information about the other (p.168). It is therefore suggesting that the trading in the index futures needed to be looked closely and decided immediately once movements in the price ceiling occur. Between options and futures, the significant difference lies on the fact that options give the owner the right to buy or sell the asset at expiration, while the holder of a futures contract is obligated to complete the terms of the contract. Stocks that are extremely versatile securities are called options and they can be used in various transactions in futures. Oftentimes, Traders in futures make use of options to do a relatively risky practice of speculation while traders who are familiar with hedgers use options to minimize if not totally erase the risk involved of holding assets. This discussion paper does not claim authority on the subject matter but it expects to be precise and correct for the sake of those who are not fully oriented about the concepts and processes in the trading index future. The style of this paper is analytical and qualitative since some people were interviewed to seek their expert opinion on this matter and ideas from literatures about the underlying subject matter were cited.

Trading index futures Index futures are simply understood as a futures contract on a stock or financial index. According to Hill (2007) index futures falls under a financial contract that requires a certain investor to acquire an asset or a particular seller to trade an asset at a preset future date and price. These assets may include physical commodities, financial instruments, securities which are usually negotiable certificates of deposit (CDs), bankers acceptances, US treasury bills, commercial papers, municipal notes, federal funds, and repurchase agreements (repos). Furthermore, the concept of futures contract, from the reflection of Terpstra & Sarathy (2000) specifies the quality and quantity of the principal assets which are regulated to make possible the trading on future exchanges. The futures contract could secure for physical delivery of the asset while some holders settled for the cash equivalent. This why, according to Hill (2007) futures markets are different, in the sense that it has the capability to use very high leverage. On this sense, index futures are relative to stock markets. Ordinarily, futures are applicable either to hedge or to speculate when there is movement on the price of the asset. Let us say, I am a producer of peanut butter. I could use futures to lock in a certain price and hedge. But, other investor or buyer could make speculation regarding the price movement of peanut butter by using the long or short futures. In this sense, anybody can participate even in the side street market movement using one trading decision or not worrying what individual assets to chose. In the study of Minho Kim, Andrew Szamary and Thomas Schmarz (1999), they describe the correlations of stock index futures and options contracts following the price movement of their respective indexes. The same observation was illustrated by Gulen and Mayhew (2000) and they claimed that stock index futures and option contracts are popular among financial professions and individual investors to protect their portfolio and to secure investment reward later. It led to the conclusion according to Martin Weber and Colin F. Camererb (1997) that it is easier to invest in index products than buying and selling stocks. The presence of the stock index futures and options on future, exposures to these markets can be done more efficiently and cheaply.

Advantages of trading index futures There is Lower Margins but with Greater Leverage According to the analysis of Joel Peress (2004) there is lower stock margin for stocks exchange in the index contracts in terms of percentage of contract value when viewed within the trading portfolio of shares corresponding to the index. Added to this is the higher leverage providing greater exposure to price changes and allows taking larger positions in these contracts. For example, if I bought the stocks outright in the Dow Jones Industrial Average, the most leverage available is 50%. If the DJIA were at $9,000, I would need about $45,000 to participate in the basket of stocks in the DJIA compared to the $5,400 needed to participate in the same stocks with a futures contract. Because the money I call is not needed immediately I could make assumptions and hedges to gain higher income. However, a cautioned was suggested by Robert Almgren and Neil Chriss (1999) with regard to the execution of portfolio transaction as inferior to trading future index. They cited one example in trading a highly illiquid volatile security. There are two extreme strategies involved in this extreme scenario. Trade everything now at a given high cost value or trade in equal sized packets over a fixed time at relatively lower cost. The latter strategy has a lower expected cost but this comes at the expense of greater uncertainty in normal revenue. The action to be taken now is to evaluate this uncertainty as partly subjective and a function of the traders tolerance for risk. This is the best time to prove that for a given level of uncertainty, there is the possibility to minimize the cost. And simply because of a relatively small amount of margin, even a small amount of money will be able to control a large amount of capital represented in a stock index contract or even a small change in the index level might produce a profitable return on the investment if it is right about the markets direction. Let us say, with the Standard & Poor 500 Index at 1150, the value of an S&P futures contract ($250 times the index) is $287,500, but requires an initial margin of only approximately $20,000, or about 6.9% of the value of the contract. It is not unusual to have daily swings of 20 points (or $5,000) in S&P futures. If you happen to catch the whole move correctly, thats about a 25% return on your margin in one day (Waldock, 2009, p. 3).

It is has Deep, Constant, and Growing Liquidity In this type of trading we can see the volume and open interest in the stock indexes as it continue to grow. Through the monitoring system, we can check and validate our assumptions through the indication of the growing liquidity and strength of these contracts. Based on the investigations of Christos Floros (2007) he presented that in the price open interest relation for stock index futures, there is daily reporting of the open interest position whereby traders can see if there are increases or decreases in the quantity of contracts that qualified for trading on each particular period. Floros (2007) also reiterated that the consistent observing, watching and checking of the progress each day in the open interest figures, the possibility of arriving at some conclusions at the end of the trading sessions could be established right away. When there is an increase in open interest, it suggests that money flows into the market coming from new traders. In the declining open interest there is a great possibility that the market is liquidating or replenishing its supply of money. It only means that the current price trend is closing and would soon end. It can be concluded that this characteristics of trading index futures are beneficial and advantageous to traders to protect their money before the next movement in the market price. Availability of Multiple Trading Strategies Stock index futures are easy to use whether traders are bullish or bearish. Shorting stock index futures can be easily executed if the investor is not subject to uptick rules, fees, or loans for short-selling as in the case with stocks. There is always the possibility to use the contract for outright speculative gain or to hedge all or part of the investment portfolio. Hedging is a strategy applied to minimize the risk of losing the money. Other financial analysts like Ederington (1979), Howard and DAntonio (1984), Pennings and Meulenberg (1997), Floros and Vougas (2006) treat hedging as a strategy in trade futures to lessen risk. Though they may have different ideas on its effectiveness, but the mere fact that there is a strategy to hedge the traded stocks index futures can be remedied when the expected outcome did not turn out favorable. In the literature review of Floros and Vougas, they came up with an early measure of hedge effectiveness which was introduced by Markowitz (1959). Markowitz measures hedging effectiveness in accordance to the reduction of the standard deviation of portfolio returns

associated with a hedge. In this case, the greater is the reduction in risk, the greater is the hedging effectiveness (Floros, et al., 2006, p. 8). Ease of Tracking Unlike the older times, stock trading monitoring was done inside the trading rooms and traders haggle with each other to get a good call or put. At present understanding price changes in the stock indexes is simple because they are contained in a well-known, often referenced companies in the advertising section of the print media. The indexes are price-weighted, which means that a dollar change in any of these stocks will have an equal effect on the index. Quotes on stock index futures are available online or by calling the broker. On October 2008, according to the report on the BBC trade index futures, stock index futures based on blue-chip stocks in the Dow Jones Industrial Average stood at $7,757 during the entire trading session. The margin for DJIA futures is about $4,000 per contract. It is not likely that traders would trade three contracts with this size account, but for purposes of showing return on investment, let us assume that we are going to buy three DJIA futures contracts with $12,000. The Dow Jones Industrial Average rallies to about $9,265 by December 31 2008, a gain of 1,508 points per contract or 4,524 points altogether. At $10 per point, the account stands at $45,240, a gain of $33,240 commissions are not included here, or a return of more than 250% on the original $12,000 margin Stock index futures add elasticity to the portfolio in several ways (BBC Trade index, 2009, p. 4 5). The Lind Waldock Trading Watch (2009) reported that futures are already be accessible on different pages of leading stock indexes such as the S&P 500 or DJIASM, on more technologyoriented indexes such as the Nasdaq-100, on broad indexes such as the Russell 2000, on international stock market indexes such as Japans Nikkei or the U.K.s FTSE-100 stock market indexes. Modern technology nowadays has made it virtually possible that there is stock market exposure and available stock index contract to show or take advantage of it. Stock index futures are already available and suited to almost any type and size of account. The S&P 500 for example may register a margin of $40,000 or higher, buyers can still trade the smaller E-mini S&P or DJIA futures for about one-fifth the amount. These margin requirements can change as the markets moved that is why the need to close monitoring of the daily turn out of buyers and sellers is an advantage.

Most major stock index futures have offering options on the futures contract and increasing available strategies to apply on almost any type of market condition. Traders then should remember that stock index futures and options are short-term trading vehicles with a time limitation therefore these are not buy-and-hold investments that can be left unattended. While the Dow, S&P, and NASDAQ trade on the open auction platform during regular trading hours, they also trade electronically overnight. The mini-sized contracts are fully electronic and trade almost 24/7 just to accommodate tracking and monitoring. This type of electronic platform provides a level of easy access and tracking not only for new accounts but also for old and nearing maturity futures. The disadvantage of this kind of open auction platform is the orders are executed anonymously and on a first-in, first-out basis - no preference is given to market makers. Conclusion Having already pointed out some major advantages of futures trading index, it can be wrapped up into simple languages that can convey what futures trading index and trading the portfolio of shares corresponding to the index actually operate. Generally, futures are temporary agreement for transactions or contract involving money that is to complete a maturity period. The concept of futures is designed for investors who hold sum of money and hope to earn more in the stock market. However, putting money in futures is not simply buying a share from a stock portfolio but a consistent monitoring and immediate strategic action is required to avoid the risk of losing the invested amount or a shifting from the expected return of investment calculation. Index futures can give quick exposure to the stock market and allows time to decide what to do on a more permanent basis. In the last analysis, index futures are meant to be short-term positions and not for a long term holding strategy.

Bibliography Almgren, R. and Chriss, N (1999) Optimal Execution of Portfolio Transaction Unpublished Report, University of Chicago, pp. 7 - 8 BBC, (2009) The Lind Waldock Trading Watch, News and Market edition, October, p, 3 Christos F. and Vougas D. (2006) Hedging Effectiveness in Greek Stock Index Futures Market, 1999-2001 International Research Journal of Finance and Economics, Issue 5 Euro Journals Publishing, Inc. . 8 9 Christos. and Dimitrios V. (2007) Lead-Lag Relationship between Futures and Spot Markets in Greece: 1999 2001, International Research Journal of Finance and Economics, Issue 7, EuroJournals Publishing, Inc. p 20 Christos, F. (2007) Price and Open Interest in Greek Stock Index Futures Market, University of Portsmouth, SAGE Publication, pp. 191 - 192 Ederington, L. H. (1979), the hedging performance of the new futures markets, Journal of Finance, No. 34, pp. 157-170. Howard, C., and DAntonio, L. (1984), A risk-return measure of hedging effectiveness, Journal of Financial and Quantitative Analysis, No. 19, pp. 101-111. Huseyin G. and Stewart, M. (2000) Stock Index Futures Trading and Volatility in International Equity Markets, The Journal of Futures Markets, Vol. 20, No. 7, John Wiley & Sons, Inc.pp. 661685 Hill, C. (2007) International Business. 6th Edition, McGraw Hill Companies, Inc. USA. Kim, M, S. $ Schwarz, T. (1999) Trading Costs and Price Discovery across Stock Index Futures and Cash Market, The Journal of Futures Markets, Vol. 19, No. 4, 475498 John Wiley & Sons, Inc. pp.475 - 476 Markowitz, H. M. (1959), Portfolio selection: efficient diversification of investments, John Wiley and Sons, Inc., New York Pennings, J. M. E., and Meulenberg, M. T. G. (1997), Hedging efficiency: a futures exchange management approach, Journal of Futures Markets, No. 17, pp 599-615. Peress, J. (2003) Wealth and Acquisiiton, and Portfolio Choice The Review of Financial Studues, Vopl. 17, No. 3

Terpstra, V & Sarathy R. (2000) International Marketing, 8th Edition, The Hyden Press, Harcourt College Publishers, USA. http://www.investopedia.com/money_market (access April 30, 2009)

Appendices Sector Weightings of the Major U.S. Stock Markets Sector Industrial Consumer Non-Cyclical Consumer Cyclical Technology Health Care Basic Materials Financials Telecom Energy Utilities DJIA 25.5 15.6 14.1 13.7 9.3 8.0 7.8 3.2 2.8 0.0 S&P 11.3 9.8 13.6 14.3 14.9 2.6 20.7 4.4 5.8 2.6 Nasdaq 100 1.9 19.1 10.0 48.4 0.0 0.5 0.0 20.1 0.0 0.0

The Dow

CBOT Dow Futures Overview Contract Symbol Dow Futures Open Outcry: DJ Electronic: ZD $10 x DJIA futures price Contract Value e.g. $80,000 if DJIA futures price = 8,000 Mar, Jun, Sep, Dec 1 index point = $10 Open Auction: 7:20am - 3:15pm Mon Fri Electronic: 8:15pm - 7:00am Sun Fri E-Mini $5 Dow Futures YM

$5 x DJIA futures price e.g. $40,000 if DJIA futures price = 8,000 Mar, Jun, Sep, Dec 1 index point = $5

Contract Months Minimum Fluctuation

Hours (CTS)

Electronic: 8:15pm - 4:00pm Sun - Fri

Source: CBOT, Contract specifications subject to change without notice.

S&P 500

S&P 500 Futures Overview Contract Symbol S&P Futures SP $250 x S&P futures price: Contract Value e.g. $225,000 if S&P futures price = 900 Mar, Jun, Sep, Dec 10 index points = $25 Open Auction: 8:30am - 3:15pm Mon Fri GLOBEX: 3:45pm - 8:15am Sun Fri E-Mini S&P ES $50 x S&P futures price: e.g. $45,000 if S&P futures price = 900 Mar, Jun, Sep, Dec 25 index poinst = $12.50

Contract Months Minimum Fluctuation

Hours (CTS)

Electronic: 5:30pm - 3:15pm Sun - Fri

Source: CME, Contract specifications subject to change without notice.

NASDAQ 100

NASDAQ 100 Futures Overview Contract Symbol NASDAQ Futures ND E-Mini NASDAQ NQ

Contract Value

$100 x ND futures price - $20 x ND futures price e.g. $120,000 if ND e.g. $24,000 if ND futures price = 1200 futures price = 1200 Mar, Jun, Sep, Dec 0.50 index points = $50 Open Auction: 8:30am - 3:15pm Mon Fri GLOBEX: 3:45pm - 8:15am Sun Fri Mar, Jun, Sep, Dec 50 index poinst = $10

Contract Months Minimum Fluctuation

Hours (CTS)

Electronic: 5:30pm - 3:15pm Sun - Fri

Source: CME, Contract specifications subject to change without notice.

Investopedia explains Option

In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.

For example, because the option writer will need to provide the underlying shares in the event that the stock's market price will exceed the strike, an option writer that sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option, as that is how he or she will reap maximum profit.

This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise, because if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit.
most stock index futures trades can be accomplished quickly and efficiently. Not every stock index futures market has sufficient liquidity to allow easy entry and exit with minimum slippage, but markets such as S&P 500 futures can handle almost any size order at any time during the trading session. With

7 8
electronic trading in contracts such as the E-mini S&P 500, trading sessions are now stretching almost around the clock. Many mutual funds require investors to wait until the end of the day to see at what price they were able to purchase or sell shares. With todays volatility, once-aday pricing may not give you the maneuverability to take positions at exactly the time you want. Stock index futures give you the opportunity to get into or out of a position whenever you want and often within seconds of receiving your order

Index Option What Does Index Option Mean? A call or put option on a financial index. Investopedia explains Index Option Investors trading index options are essentially betting on the overall movement of the stock market as represented by a basket of stocks. Options on the S&P 500 are some of the most actively traded options in the world.

Why now is the perfect time to invest... *** The first share for our Dummy Portfolio... *** The cold hard truth about investing and more... Dear Investment Academy reader, We all know that the markets took a nosedive in 2008. Those who were heavily invested took a pretty bad knock and new investors are now afraid to take the next step and invest in their first shares. This is exactly what I want to talk to you about today. Why investing NOW can produce excellent long-term gains. My plan for the year is to select a few shares that I think will do well in 2009. Each week Ill update the share prices from the date we selected it and you can see how well or badly the shares performing. Im going to discuss two shares today. One, Im placing on our watch list and the other Im placing in our new Investment Academy Dummy Portfolio. Well track the performance of these shares in the Dummy Portfolio throughout the year and hopefully put your investment fears to rest. Before we continue, Id like to highlight something upfront. Im NOT recommending that you run out and buy these shares. This portfolio is for demonstration purposes only. What I want to prove is that, even in an unstable market, there are shares that present excellent growth for 2009. But we'll have to wait and see how we get on. Lets get straight into it Heres the cold, hard truth Theres no doubt in my mind, the JSEs going to have an extremely difficult time recovering in 2009. According to BOE Private Clients investment research team, the economys only going to grow between 1% and 2% this year.

But, as we approach 2010 and the FIFA Soccer World Cup, Im confident that our local market is going to flourish again. This is one of the main reasons why you should be looking for good quality shares at their current low prices. Theyre perfect for a three to five year (long-term) investment strategy. Many good quality shares are finally affordable! Lets take Sasol (SOL) as an example: Source: Sharefriend This graph (above) shows you the movement in Sasol's share price since 7 January 2008. Sasol was trading at around R360 at that time. The share price climbed drastically and peaked above the R550 mark in May 2008. Most global markets were already falling. But the problems only hit us when commodity prices started tanking. The local markets began to feel the pain and the share price went into a downward spiral. Today, Sasols trading at R278.00. Thats even cheaper than it was at the beginning of 2008!

But is that enough to make Sasol a good investment for 2009? The first thing we need to look at is the news. Sasols been hit with another price fixing scandal. Thats the second scandal in less then eight months. (First it was the wax cartel issue and now its a gas issue.) We could see the share price fall even lower, but itll never stay down there forever. Im going to keep my eye on this share in 2009. I wouldnt add it to the Dummy Portfolio right now, not with all the problems relating to the competition commission looming over its head. But, Ill follow the share price and the share very closely and wait for the perfect time to add it to our Dummy Portfolio. Sasol's also linked to the oil price. There are rumours that the fuel price will be rising again next week. But, theres nothing wrong with waiting before making that crucial buy. So what should you do now? There are many shares like this on the market at the moment, offering value not seen in years. You just need to keep your ear to the ground and get your timing as right as possible.

Heres an example of a great share that seems to have everything poised for a good year in 2009. Anglo American (AGL) - A solid blue chip for the Dummy Portfolio Source: Sharefriend Take a look at the graph of Anglo American above. This share was doing really well until the markets started diving in 2008. Its currently trading at R190.00 - thats 65.89% off its 12 month high of R557.00. Its currently on a PE of 5.09. The management of the company can be proud. Theyve dropped capital expenditure for 2009. Its been capped at $4.5 billion, a reduction of more than 50%. This massive drop means there will be a drive to stop unnecessary spending in the current market conditions and focus on the projects thatll bring in the best production for 2009. Anglo American is well positioned to weather the current weak economic conditions and to continue to prosper for the benefit of all our stakeholders." - Cynthia Carroll, Chief Executive of Anglo American This is a quality share, at an affordable price. And Id like to test drive it for the year. Im going to add this to our Dummy Portfolio for 2009. Once the markets settles down, this share should rebound nicely. Its already following a strong upward trend and I hope to see more throughout the year. Lets make 2009 a year of communication Thats it from me for today But before I sign off, just two more things: 1. Remember, this is a hypothetical portfolio and I do NOT advise you to buy any of these shares, 2. Lets make the Investment Academy Dummy Portfolio a team effort. If you have a share that you think is going to be a stellar performer this year, send me your reasons for this selection to iacomment@fsp.co.za. If its a good one Ill add it to the portfolio.