How do S&P 500 futures work?

S&P 500 futures are a type of derivative contract that provides a buyer with an investment priced based on the expectation of the S&P 500 Index’s future value. S&P 500 futures are closely followed by all types of investors and the financial media as an indicator of market movements. Investors can use S&P 500 futures to speculate on the future value of the S&P 500 by buying or selling futures contracts. Investors basically have two choices when seeking S&P 500 futures. The Chicago Mercantile Exchange (CME) offers an S&P 500 futures contract known as the ‘big contract’ with a ticker symbol of SP. It also offers an E-mini contract with ticker symbol ES.

Introduction to S&P 500 Futures

The first S&P 500 futures contracts were introduced by the CME in 1982. The CME added the E-mini option in 1997.

The SP contract is the base market contract for S&P 500 futures trading. It is priced by multiplying the S&P 500’s value by $250. For example, if the S&P 500 is at a level of 2,500, then the market value of a futures contract is 2,500 x $250 or $625,000.

E-mini futures were created to allow for smaller investments by a wider range of investors. The S&P 500 E-Mini Futures are one-fifth the value of the big contract. If the S&P 500 level is 2,500 then the market value of a futures contract is 2,500 x $50 or $125,000.

The ‘E’ in E-mini stands for electronic. Many traders favor the S&P 500 E-Mini ES over the SP not only for its smaller investment size but also for its liquidity. Like its name, the E-Mini ES trades electronically which can be more efficient than the open outcry pit trading for the SP.

Like with all futures, investors are only required to front a fraction of the contract value to take a position. This represents the margin on the futures contract. These margins are not the same as margins for stock trading. Futures margins show ‘skin in the game’ which must be offset or settled.

Cash Settlement of S&P 500 Futures

Industry experts created the cash settlement mechanism to resolve the massive logistical challenges presented by delivering the actual 500 stocks associated with an S&P 500 futures contract. Not only would the stocks have to be negotiated and transferred between holders, but they would have to be properly weighted to match their representation in the Index. Instead, an investor picks a long or short position, which is then subject to a mark-to-market. The investor pays any losses or receives profits each day in cash. Eventually, the contract expires, or is offset, and becomes cash settled based on the spot value of the S&P 500 index.

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