1. Money

What are Dow Futures and How Do They Work

A Basic Introduction to Dow Futures Contracts

By

Have you ever picked up the newspaper or watched CNBC and wondered what the reporters were talking about when they discussed the Dow Futures and the influence they would have on the direction of the stock market? This will service as a quick introduction to Dow Futures and help you understand a little bit about them.

The Basics

First, we must begin with the basics. A futures contract is a legally binding agreement between two parties (which can be individuals or institutions) in which they agree to exchange money or assets based upon a relationship to a predetermined price of an underlying index. Relax - it's not as complicated as it sounds. All it means is that two people get together and strike a deal in which they say, "If the Dow Jones Industrial Average index is at or above (insert price here) by a certain date (called the "final settlement date") then one party will pay another the difference between the actual closing price of the index and the predetermined price upon which we agreed when we entered into the contract." Unlike an option, which gives the holder the right but not the obligation, to exercise the terms of the deal, in a futures contract, both parties must perform their part of the deal.

Dow Futures contracts trade on an exchange, meaning that the exchange serves as the counter-party of every position. Otherwise, you would always have to worry about the person who held the other side of your position. If they were to go bankrupt, die, or be unable to fulfill their side of the deal, you would be out in the cold; a perfectly good position could go belly up because they couldn't live up to their side of the bargain. By having all of the futures contracts cleared through the options exchange, this risk is eliminated because the exchange serves to guarantee every position.

Dow Futures have built-in leverage, allowing traders to make substantially more money on price fluctuations in the market than they could by simply buying stock outright. The multiplier for the Dow Jones is 10, essentially meaning that Dow Futures are working on 10-1 leverage, or 1,000%. If the Dow Futures are trading at 7,000, a single futures contract would have a market value of $70,000. For every $1 (or "point" as it is known on Wall Street) the Dow Jones Industrial Average fluctuates, the Dow Futures contract will increase or decrease $10. The result is that a trader who believed the market would rally huge could simply acquire Dow Futures and make a huge amount of profit as a result of the leverage factor; if the market were to return to 14,000, for instance, from the current 8,000, each Dow Futures contract would gain $60,000 in value (6,000 point rise x 10 leverage factor = $60,000).

The Dow Futures begin trading on the Chicago Board of Trade at 7:20 a.m. Central Time (8:20 a.m. Eastern Time), which is an hour and ten minutes before the stock market opens. That allows trading to take place before the actual stock market opens so reporters and professionals can get an idea of sentiment. That is, if a company reports huge earnings and the Dow Futures skyrocket, the odds are good that the market itself will raise as well. The opposite is also true. If an event occurs before the stock market opens that causes Dow Futures to plummet, then it's a fairly good chance that stocks will fall once the opening bell rings.

©2014 About.com. All rights reserved.