Investing

What the stock futures market is, and why experts watch

Twenty/20

In recent weeks, the daily lurches up and down in the stock market have been broadcast well before the official open of trading at 9:30 a.m. in New York. That's thanks to information from overnight trading in the futures market.

Traders can buy or sell futures contracts for the major U.S. stock indexes, which essentially allow them to wager on the future value of those benchmarks. If S&P 500 futures are down, that suggests traders think the index itself is headed lower.

Futures contracts allow people to buy or sell an asset at a future date at an agreed-upon price. In addition to those major stock benchmarks, there are futures contracts for a variety of other assets including individual stocks, currencies, bonds, and commodities.

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While people on Wall Street have always tracked the futures market, you may have heard more about it recently. Here's what you need to know.

Why people trade futures

There are two primary types of futures traders: Hedgers and speculators. The difference boils down to whether the trader actually intends to eventually own the underlying product.

When it comes to hedging, traders will buy (or sell) futures contracts to lock in a specific price for an asset now, in the event there are big price changes in the future. Airlines and food manufacturers are examples of companies that might use futures for this purpose. That's because their businesses rely heavily on particular commodities, like oil or wheat, and they don't want to be surprised if prices go up suddenly.

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Meanwhile, speculators might trade futures to place a bet on the future direction of a particular asset. These traders never intend to actually own that product. S&P 500 futures are a popular asset for these types of speculators.

Big price jumps that occur in the U.S. stock market often are foreshadowed by futures trading, which might reflect moves in other markets around the globe overnight. And that's why experts pay attention to this market.

Futures don't necessarily make sense in the portfolio of long-term investors because these securities inherently have a shorter investing time frame than most experts recommend.

Futures and the stock market

The U.S. stock market is open weekdays from 9:30 a.m. to 4 p.m. in New York. But there's news that happens outside those hours, and the futures market allows traders to more quickly react to that information. That said, pre-market activity in stock futures can differ from what happens when the market opens, as the latter experiences much more trading activity.

For stock futures, the market is open during much of that time the regular market is not. Trading begins at 6 p.m. on Sundays in New York and the market remains open until 5 p.m. on Fridays, with a trading halt every day from 4:15 p.m. to 4:30 p.m.

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In recent months, news has broken related to the coronavirus pandemic during times when the stock market is closed —and that's resulted in some swings in the futures market that predict what will happen when the market reopens.

If you check financial news before 9:30 a.m. New York time, you may see stories with wording like: "Futures point to a 3% drop at the open." That's because based on what happened overnight in the futures market, traders can expect similar activity to continue once the broader market is open. 

After the stock market closed on March 31, for example, President Donald Trump said the U.S. should prepare for a "very, very painful two weeks" as a result of the coronavirus outbreak. S&P 500 futures slumped overnight and that index ultimately fell 4.4% on April 1.

Futures and your portfolio

While trading futures contracts isn't likely something that most long-term investors will ever do, it still can be helpful to understand how this niche market relates to the broader stock market. And as illustrated above, it's possible to see how traders react to major news instantaneously based on what's happening with stock futures.

Understanding how futures works is a bit like understanding stock tickers: helpful to know, but not essential for long-term investing success.

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Instead, experts caution that you shouldn't worry too much about these types of short-term price changes. Use the information to deepen your understanding of markets rather than to inform your investment strategy. Learning about the market more broadly can also help you to embrace your role as an investor.

Thinking like an investor and learning more about your portfolio will help you to appreciate the market's long-term track record of success. And, in turn, that can help encourage you to continue adding money to your accounts whether the market is looking down or up.

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