Futures in the stock market refer to contracts in which you promise to make a purchase of bonds, stocks, commodities or currency at a future date. Futures are regulated and must be executed on the date defined in the contract. Fair market value is the current value of the stock. Fair market values are estimates based on a number of factors, including history of the stock, company performance and general market activity.
When the futures price and the fair value are similar, your investment in the futures contract is performing appropriately, with little risk. It’s when the similarities between the two numbers fluctuate that you should look at your holdings to determine if you need to close your futures contract or get out while you’re ahead to prevent further losses. Another strategy used to prevent significant losses is to hedge your bets by placing an order to sell the futures contract if it reaches a certain price, also known as a “put option.”
You may close a futures contract in a number of ways as long as you pay the margins due at the time. Margins are controlled by the overseeing agencies that guarantee the payoff of futures contracts and must be satisfied before you may cancel a futures purchase. To exit a futures commitment, you may take delivery of goods, make an offsetting trade or make arrangements for a goods exchange. Your profits and losses are recognized in your earnings statement when you sell your futures contract.
The difference between the fair value and the stock market futures is called the spread. Predicting the spread at the opening is difficult because trading occurs after hours and is reflected in the opening prices of the stock. The price of futures continues to change during the day, often leaving you with an unpredictable fair value price at any given time during the day. According to economist Hans R. Stoll at Vanderbilt University, institutional stock traders have powerful computing programs that keep them abreast of instantaneous futures changes and are able to react just as quickly. As an individual investor, it’s very difficult to keep up with the rapid changes, thus making fair value versus futures an unreliable measure for your daily trading decisions.
Futures are set up on regular payment schedules four times a year. Nasdaq futures contracts expire in December, September, June or March. Fair value amounts change daily and decrease accordingly as you get closer to your futures expiration date. According to the Financial Industry Regulatory Authority, stock market futures rates may be risky because once the fair value is determined, it won’t change again until the next day and you want to be able to predict the changes before they occur. Another risk you take is that if the fair market value drops below your purchase price, it could drain your brokerage account and require additional deposits just to cover your margin. Additionally, it’s not always as easy to get out of futures contracts as you may have been led to believe.
- All Business.com: Hedging
- Eagle Traders: Valuation and Accounting of financial Instruments
- George Mason University: Stock Index Futures
- Vanderbilt University: Market Microstructure by Hans R. Stoll
- Financial Industry Regulatory Authority: Security Futures
- Morningstar: How Fair Value and Target Price Differ
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