Does index futures curve go into contango in a bull market?

Discussion in 'Index Futures' started by learner88, Feb 15, 2018.

  1. learner88

    learner88

    Financial speculators who think that a stock index is going to rise a lot for the year will want to buy index futures dated far into the year at a higher price because they expect the price to go up. Hence, if index futures curve is in contango, it means the market is forecasting a bull market ahead. Likewise, if the curve goes into backwardation, the market is forecasting a bear market ahead.

    Is my understanding? Correct me if I'm wrong. I'm new to index futures and still making losses.
     
  2. Quiet1

    Quiet1

    Index futures are instruments whose payoff should be equal to that of a trader who buys all the stocks in the index at their index weights with borrowed money at the same time and holds them until the expiry of the future collecting dividends along the way. That's it. The future is higher than the spot index price if the interest rates cost of that borrowed money exceed the value of the dividends received. That's why when interest rates have been very low in recent years the future traded below spot.

    Because *trading* futures is cheaper than trading all the stocks it can sometimes briefly be a little higher or lower than it should be. This can be and is mechanically arbitraged so that it doesn't last too long.
     
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  3. Robert Morse

    Robert Morse Sponsor

    The spread between months in index futures is based on cost of carry-interest and dividend flows of the hedge which is the basket of stocks. That should only change when interests rates and dividends change.
     
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  4. tommcginnis

    tommcginnis

    I started a thread on this subject back in November -- there's a fair set of observations there, between SPX and ES. (Along with ET-snark, which you can ignore...) You might want to have a look-see.
    https://www.elitetrader.com/et/threads/esspx-3pts-here-comes-the-interest-rates.314732/
    Having made the observation (and knowing it to be something of great foreboding), I am still disappointed that I remained caught up in the current market, and missed the message: it was institutions, preparing for higher rates. It foretold:
    market turmoil and a material pop in VIXies.
    a slap at interest-rate-sensitive stocks
    a "unplug" of the [retail$$-ied ETF-driven] climb across the markets.

    Two things I will watch long into the future:
    differences between
    HV and IV
    and
    Index and future.

    Maybe I should start a list, on Things To Watch, No Matter The Other Noise:
    net liq.
    p/e
    [Index-future]
    [IV-HV]
    ADX/DMIs and ATR
    gamma (or, delta/gamma ratio)

    * possibly in relevant order...

    Sheeesh! I think that's about it.
     
    Last edited: Feb 15, 2018
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  5. Unlike other products where it's cumbersome to do the cash - it shouldn't get too out of line because the cash n carry trade would bang it back into place. If the forward/futures price got to too high or too low - arbs would bang it back with a risk-less trade. It could exist for a while. The market makers would do it as they live for this kind of mispricing.
    If it's a product where the cash n carry is cumbersome then that is different.

    Let's for sake of argument say your 1 year rate was 5% and no dividends. A future trading at 105 with the spot at 100 - going out 1 year is at fair value. If it were trading at say 108 - you would buy the spot and sell the future for a risk-less 8% in a 5% world. Invert the trade when it's too cheap. Doesn't work well for products where it's hard or cumbersome to trade the cash/spot. Essentially you are making 8% T bills in a 5% world. I made it very black and white - things like dividends complicate it.
     
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  6. JackRab

    JackRab

    Equity Index Futures are only in contango when the (risk-free) interest rate component is bigger than the dividend component...

    The fact that an index future with a longer dated expiry is higher than a front month future has only to do with this... if it's 3% higher than the front month, it means the interest-/-dividend is about 3%.

    If it's roughly equal... it's because interest rate = dividend

    If it's lower... than dividends outweigh the interest component.

    When spot = 2600 and 1yr-future = 2650... it doesn't mean traders think that the index will be at 2650 at the end of the year. It means that if you would want to get the same return as the risk-free rate... you want the index to end up at 2650. It's about financing...

    That's it... nothing more to it. Derive from it what you want...

    EDIT.. "and only if the index isn't calculated by reinvesting the dividends..." this is incorrect.. obviously when dividends are not reinvested there's a good chance that futures go into backwardation when dividends are larger than the interest component... duh... mix-up...
     
    Last edited: Feb 15, 2018
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  7. learner88

    learner88

    Thank you for all the replies. I now know that index futures cannot be used to forecast future index prices. I got this impression because I come across news articles about traders using interest rate futures to forecast about future interest rate movement. So, I thought the same can be applied to index futures.

    I still have lots to learn about index futures. No wonder I am still losing money. Thanks a lot!