In this post, I’d like to share my thoughts on stock index futures and why I think they’re worth considering (though this doesn’t mean you should get them).
What are stock index futures?
Stock index futures are financial contracts that obligate the buyer to purchase, or the seller to sell, a stock market index like the S&P 500 at a predetermined price on a specific future date. They allow investors to speculate on or hedge against future changes in an index without owning the underlying stocks.
One key advantage is the ability to use high leverage without taking out a loan. No loan means no interest payments, which saves money. Leverage lets you control a large investment with a small amount of capital, amplifying both potential gains and losses.
Isn’t high leverage bad?
This is where nuance matters. High leverage does mean higher risk, but it also offers the potential for higher returns. That said, there are ways to manage risk some of which you may already be doing:
- Small capital: You can’t lose much if you don’t have much to begin with. Starting small limits your exposure.
- Dollar cost averaging: Investing a fixed amount regularly say, monthly reduces risk over time. While this may yield lower returns compared to lump sum investing, it’s often better for risk management and fits well with salaried workers who invest each paycheck.
- Young investors: If you’re young with a long career ahead, you have time to recover from losses through future income, softening the blow of a bad trade.
Eventually, once you’ve accumulated sufficient capital, your absolute risk increases because you’re investing more. At that point, it makes sense to reduce risk by buying fewer futures contracts and diversifying into other financial instruments.
It’s also worth noting that sometimes higher returns can offset the increased risk, which is something to keep in mind.
When to consider reducing leverage
As your wealth grows, knowing when to scale back risk becomes important. Here’s a rough framework I use to estimate when to reduce leverage. Adjust it based on your own situation.
I’d consider reducing leverage when I can sustain myself without working. Reducing leverage doesn’t mean eliminating it, just scaling it down.
A common rule of thumb is the 4% annual withdrawal rate. For example, if I need $20,000 annually:
$20,000 ÷ 4% = $500,000
So, I’d want at least $500,000 in total investment value before dialing back leverage. With 10x leverage via futures, that would require just $50,000 in actual capital to control $500,000 worth of exposure. As your capital grows past this point, there are various ways to reduce risk.
How (and how Not) to derisk
Essentially, you’re looking for investments that offer returns but are not highly correlated with your futures exposure. This is tricky because most investments are at least somewhat correlated but that’s fine. You can still work around it by diversifying enough to dilute correlation.
I’d break derisking strategies into two categories: “I have no alpha” and “I have alpha.”
Alpha measures an investment’s performance relative to a benchmark. If you consistently outperform the market through skill or strategy, you have alpha. If not, you likely don’t and that’s okay.
Not like this
A derisking method I wouldn’t recommend is simply swapping futures for ETFs. While it reduces leverage, it also diminishes return potential. It’s essentially the same as holding cash (not even bonds just cash). Instead, consider reducing the number of futures contracts and reallocating the freed up capital into assets that are at least somewhat uncorrelated, like bonds.
No alpha
- Bonds: A straightforward and effective way to reduce correlation and risk.
- Other index futures: Holding futures from multiple indices can slightly reduce risk, though most indices are still correlated.
- REITs: Real Estate Investment Trusts offer exposure to income producing real estate. While they provide diversification, I believe they may underperform going forward so I’m not enthusiastic about recommending them.
Alpha
If you do have alpha, it’s an excellent derisking tool because alpha is, by definition, uncorrelated. Examples include:
- Buying individual stocks you believe will outperform
- Investing in country or sector specific ETFs
- Shorting assets you expect to underperform
However, having alpha requires high conviction backed by research, domain knowledge, or insider information (ethically acquired, of course).
How do stock index futures work in practice?
Stock index futures track an index like the S&P 500 and allow you to bet on its future value. To trade them, you’ll need a brokerage account that supports futures and a margin account. You deposit funds (margin) to cover potential losses, enabling leverage that can magnify gains or losses.
Micro E-mini S&P 500 Futures Contract
This contract is designed for smaller investors. Its multiplier is $5 per point. So, if the S&P 500 is at 5,000, the notional value is $25,000 ($5 × 5,000). With 10x leverage, you’d only need $2,500 in margin.
Example:
If the index rises from 5,000 to 5,100, you’d earn $500 (100 points × $5). If it drops to 4,900, you’d lose the same. These contracts typically expire quarterly, so you’ll need to close or roll them over.
Why the Micro E-mini?
Regular S&P 500 futures are large. Here’s how they compare:
| Contract Type | Multiplier | Notional Value S&P 500 = 5,000 |
Margin 10x Leverage |
Relative Size |
|---|---|---|---|---|
| Standard S&P 500 | $250/point | $1,250,000 | $125,000 | Standard |
| E-mini S&P 500 | $50/point | $250,000 | $25,000 | 1/5 of Standard |
| Micro E-mini S&P 500 | $5/point | $25,000 | $2,500 | 1/10 of E-mini |
The Micro E-mini is far more accessible for retail investors, allowing greater flexibility and risk control.
Tax Considerations
In the U.S., futures are taxed under the 60/40 rule: 60% of gains are treated as long term capital gains, and 40% as short term, no matter how long you hold the contract. This can be more favorable than other investments, but rules vary by country so check yours.
Further Reading
In the next post, I’ll explain why I chose the Russell 2000 index.
Feedback
Have suggestions or critiques? Feel free to email me:
splonk@splonk.party
Thank you for your attention to this matter!