Analyst Insight
Introduction
A futures contract is a derivative contract agreement to buy or sell a particular asset at a predetermined price at a specific time in the future. A futures market is a market where participants can actively trade futures for delivery or cash settlement at a specified date. Futures contracts can be used by commercial operators and investors to hedge an existing price exposure or to speculate on the future price of an underlying asset. If a trader has a strong belief that a particular asset or index is expected to rise over a short to medium timeframe, they would go long a futures contract, or on the contrary, if there is a negative view, the investor would go short the futures contract. Investors can also actively keep abreast of the futures market to gauge bearish or bullish sentiment around an index, commodity, or financial asset. Futures markets trade roughly 23 hours a day with the exception being weekends, giving insight into pre-market and post-market sentiment and directional trends.
Understanding the Futures Markets
A common way investors participate in the futures markets is through stock index futures, tracking indices such as the S&P 500 and the Dow Jones Industrial Average. Stock index futures reflect expectations about the price of a stock index given current market conditions such as interest rate levels and other economic events. Any rise or fall in the index futures occurring after the close of the underlying spot market can be used as an indication of where the market will open the following day in the underlying spot market. To fully contextualize stock and index futures, it is important investors understand basic terms around how to read market data. One such term is open interest. Open interest refers to the total number of futures contracts that are held by market participants at the end of trading each day. This number indicates how many contracts are open on the market and changes each day as investors and traders buy and sell contracts. Open interest is calculated as the sum of all opened trades, subtracting contracts when the trades are closed. A rise in open interest along with a rise in the price of the index may signal a bullish market sentiment. On the contrary, a rise in open interest along with a fall in the price of the index may signal a bearish market sentiment. An increase in the index price along with open interest remaining stable could be an indicator that the market has topped and could see a reversion. If open interest is low, it serves as an indicator that there is relatively weak participation in the market. The open interest is usually accompanied by trading volume, which shows the number of contracts traded for a specific period. Though this is not a gauge of price action, it serves as an indicator of how active the market is. Information from the CME Group for crude oil futures showed investors trimmed open interest for the second session in a row (as of September 9, 2022), with volume mirroring that trend. Despite this, the price of crude oil traded higher coming off the backend of diminishing open interest and volume, indicating that the price may not hold at these levels in the near term, and we could see very muted price movement or a fall in prices. An investor or trader can use this data from the futures market to profit on the downside if signs of a pullback become more pronounced.
Federal Funds Rate Futures and Interest Rates
Futures contracts based on the federal funds rate indicate that the market is pricing in a peak in March 2023, with the implied rate at 4.01%, declining to 3.99% in May of the same year, before tapering to 3.95% in June. Based on the implied rates from the futures for September and November, traders are pricing in a high probability of a 75-basis point (bps) rate hike at the next Federal Reserve meeting in September, and a high probability of a 50-bps hike at the November meeting. Since March of this year, the Federal Reserve has taken a hawkish stance as it looks to tighten monetary policy in an effort to reduce inflation. According to the CME Group, the probability of a 300-325 bps target Fed funds rate (75 bps hike) in September rose to 91.0% as of September 9, 2022. This could potentially weigh negatively on short-term bond prices due to the inverse relationship between bond prices and interest rates and will also weigh negatively on growth stocks as the cost of capital increases.
Conclusion
Investors can use data from the futures markets to gain insights that span a range of asset classes and make inferences about the general sentiment towards risk in the market. However, investors do not need to participate actively in the futures market as data produced from activity in the futures market may serve to give a hint as to where prices will shift. Furthermore, overnight activity can give an early indication of evolving trends developing in various markets.
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