Spread between SP Futures and SP Index

FIGURE 15-2 Trading Bands and Futures Trading, July 18, 1997

Stock index futures were launched in February 1982 by the Kansas City Board of Trade using the Value Line Index of about 1,700 stocks. But two months later in Chicago, at the Chicago Mercantile Exchange, the world's most successful stock index future based on the S & P 500 Index was introduced. Only two years after its introduction, the value of the contracts traded on this index future surpassed the dollar volume on the New York Stock Exchange for all stocks. Today the S & P 500 futures trade about 140,000 contacts a day, worth over $30 billion. Although there are other stock index futures, the S & P 500 Index dominates in the U.S., comprising well over 90 percent of the value of such trading.

All stock index futures are constructed similarly. The S & P Index future is a promise to deliver (in the case of the seller) or receive (in the case of the buyer) a fixed multiple of the value of the S & P 500 Index at some date in the future, called a settlement date. The multiple for the S & P Index future is 250 (which was changed from 500 in November, 1997), so if the S & P 500 Index is 1000, the value of one contract is $250,000.

There are four evenly spaced settlement dates each year. They fall on the third Friday of March, June, September, and December. Each settlement date corresponds to a contract. If you buy a futures contract, you are entitled to receive (if positive) or obligated to pay (if negative) 250 times the difference between the value of the S & P 500 Index on the settlement date and the price at which you purchased the contract.

For example, if you buy one September S & P futures contract at 1000 and on that third Friday of September the S & P 500 Index is at 1010, then you have made 10 points, which translates into $2,500 profit ($250 times 10 points). Of course, if the index falls to 990 on the settlement date, you would lose $2,500. For every point the S & P 500 Index goes up or down, you make or lose $250 per contract.

On the other hand, the returns to the seller of an S & P 500 futures contract are the mirror image of the returns to the buyer. The seller makes money when the index falls. In the previous example, the seller of the S & P 500 futures contract at 1000 will lose $2,500 if the index at settlement date rises to 1010, while he would make the same amount if the index fell to 990.

One source of the popularity of stock index futures is a unique settlement procedure. With standard futures contracts, you are obligated at settlement to receive (if purchased) or deliver (if sold) a specified quantity of the good for which you have contracted. Many apocryphal stories abound about how traders, forgetting to close out their contract, find bushels of wheat, corn, or frozen pork bellies dumped on their lawn on settlement day.

If commodity delivery rules applied to the S & P 500 Index futures contract, delivery would require a specified number of shares for each of the 500 firms in the index. Surely this would be extraordinarily cumbersome and costly. To avoid this problem, the designers of the stock index futures contract specified that settlement be made in "cash,"

computed simply by taking the difference between the contract price at the time of the trade and the value of the index on the settlement date. No delivery of stock takes place. If a trader fails to close a contract before settlement, his or her account would just be debited or credited on settlement date.

The creation of cash-settled futures contracts was no easy matter. In most states, particularly Illinois where large futures exchanges are located, settling a futures contract in cash was considered a wager—and wagering, except in some special circumstances, was illegal. In 1974, however, the Commodity Futures Trading Commission, a federal agency, was established by Congress to regulate all futures trading. And since there was no federal prohibition against wagering, the state laws were superseded.

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