So, now that we’ve covered the basics of the dow futures contract, and the various types of dow futures available, let me just cover some of the basic issues involved in trading these contracts, and in particular, something called fair value, how to open and close a trade, how to roll over a contract, the issues of margin, and finally the all important issue of risk management.

dow jones futures price

One of the questions I am often asked by traders who are new to futures trading, is how is the futures price derived, or is it simply the market, the exchange or some other factor? Well the answer is something called ‘fair value’ and here is a brief explanation of how this is arrived at for the dow jones futures contract. It is an important concept for you to understand, as we can often deduce the likely future direction for the index, based on whether the dow future is above or below fair value.

The first thing to understand between a futures price and the index price, is that this is not arrived at in some random fashion, but it a relationship that is largely driven by arbitrage activity in the market, and for those new to trading, let me briefly explain the term arbitrage, and its use as a trading strategy. The term arbitrage refers to the opportunities that arise from time to time in the financial markets allowing traders to benefit from small price variations which occasionally appear between two identical or similar markets. This allows a trader to make a risk free trade ( the nirvana of trading!). These price differences are generally very small, and may only last a few seconds or minutes before the markets re-balance and the opportunity evaporates, and typically they are often seen in markets operating in different time zones, where the price of a commodity, option or future may differ fractionally from the price for the same instrument quoted on another market. To make a profit requires speed, skill and large trading positions, which are generally the preserve of the professional traders, not the small retail speculator like you and me. Having said that, you do see them occasionally, particularly in the spread betting industry in the sports markets, and if you have ever read the story of Nick Lesson, you will know that this is how he started his trading career in the Far East, where small price differences in futures and options on the Tokyo and Singapore exchanges, allowed him to benefit, with risk free trades.

dow futures fair value

In the dow jones futures market, it is arbitrage that drives the futures price, for the simple reason that if the index becomes ‘over priced’ then arbitrage buyers may buy the underlying stocks in the index and then sell the futures, or alternatively the index may be perceived as under valued by an arbitrageur, in which case they would sell stocks and buy futures, once again benefiting from the price differential between the two markets and making a profit from a risk free trade as a result. In order to prevent this opportunity arising, dow jones futures are priced using the following mechanism :

  • Futures price = Cash equities + finance charges – dividends

The above calculation is based on the assumption that an arbitrageur will finance the purchase of cash equities using a loan funded with short term interest rates, which leads us to the concept of fair value. This concept of fair value is the theoretical value for the futures contract, but does not necessarily mean the contract will trade at this level, and as such we have two states for the futures contract in relation to the underlying stock index as follows :

  • Negative carry – generally stock index futures are priced at successively higher levels the further out the futures contract, as short term interest rates generally exceed the stock dividend yields
  • Positive carry – occasionally interest rates drop below dividend yields with futures contracts priced successively lower the further out into the future.

The fair value price is generally arrived at, following a survey on the last day of the month by the exchange, which derives its figures from surveys of the index constituents, regarding likely dividend payments, and coupled with an estimate of the short term interest rate then arrives at a calculation for the appropriate futures contract. Let’s look at a simple example as follows:

  • Assume the interest rates for lending is 4%
  • Assume the likely dividend yield across the index is 1.5%
  • Then using a factor of 1 for the cash index, the futures  fair value price would be:  (1 + 4/100 ) – 1.5/100 = 1.025
  • If the current dow jones index is 10,000, then the dow futures fair price is 1.025 x 10,000 = 10,250

This is why the futures value always varies from the underlying cash market value, unless we are very close to expiry, in which case the futures contract and index will be much closer together. The reason fair value is important is firstly it explains how and why the futures derivative price varies from the underlying index, and secondly it gives us a potential view on the likely direction of the market. If the dow future is reported as being below fair value, then we can expect the dow jones index to fall, and if the fair value is reported as being above then we can expect the index to move higher. Each morning you will hear this figures widely reported with statements on CNBC and Bloomberg such as ‘Futures on the Dow Jones Industrial Average are trading more than 50 points below fair value so look for a negative start in Wall Street trading later today’ – now at least you know what it means, and also confirms one other point I mentioned in my introduction – futures markets lead the cash market, not the other way round!

Finally having covered the dow futures price, let’s look at how to trade futures along with the other important aspects of futures trading which you need to understand before getting started.