Most people have heard of the futures market, and it does get mentioned on news shows such as CNBC or MSNBC. However, a lot of people dont understand what the futures market is. Learning how to utilize it properly will help with entry timing when day trading, swing trading, and even investing (after all, who wants to be down immediately after entering a position?)

It’s actually quite simple. The futures market is just a bet on where an index will close at a future date in time. It is no different than saying ” I think GE will be 5 points higher in 3 months”. Think about thousands of people, or even 10s of thousands all betting on the price of GE in 3 months. Not tomorrow, the time is 3 months from now.

This aggregate valuation call would be considered a futures market. It may be higher or lower than where GE is now, but you also have to consider the people have 3 months to be right - that is a lot of time. Time always has a value, because the more time you give yourself to be right, the easier that bet is. So the market puts this time value into the price of the futures, and each day that goes by a bit of it decays (goes away) as it gets closer to the 3 month time. This 3 month time in this example is a fixed time, it does not scroll forward. So if the bet is a close of at least X price by july 31st, 2 weeks from now the date to be right is the same but the time left is less.

If this still seems confusing, think about this example:  Every day an analyst says “The market will fall 300 points today." if that happens in just a day, he gets paid a bonus of $40,000.00.The more time anyone has to be right can happen just by random chance, given enough time until the bet expires.The time increase you might give a person to be right would actually decay the value of the prediction being right.If the guy is given 1 month to be right, that is only worth $10,000.00.It the time to be right is 3 months, that is only worth $1000.00.00 and so forth, this is a type of time decay.

This basic concept is then carried over to the stock indexes. People make bets based on all available information, and bets based on anticipated information and research for where the indexes might be in the future. One thing to remember is at the expiration date, the futures contract AND the cash contract (the index) will be identical. So if the S&P 500 index is at 1400 on expiration, so will the futures contract trade to this price. Because of this fact, there is what is called arbitrage between the 2 (cash vs futures) since they trade separately. I can make a bet on the futures market (buying or selling) without doing anything with the cash index. In just the same way, I can buy a large basket of stocks in the index without touching the futures market. This back and forth action causes the two of them to fluctuate independently.

If the futures get too high (people buying futures but not stocks), there is free money there since at expiration futures and cash are equal. So you can sell the futures, then buy the basket of stocks that make up the index and lock in free money if you hold it until expiration. There are whole other program trades that simply day trade stocks vs futures all day long based on the premium to cash being too high or too low.  By selling the futures, you have agreed in principal to sell the basket of stocks comprising the index at that futures price. If the futures are 1430 and the cash is 1400, and the time value is 20, theoreticaly the futures should be at 1420. At 1430, I can sell the futures, then buy the stocks and lock in 10 points for free. Doing it in real time is not this easy, but the basic underlying concept is.  Anyone who wants to learn to trade needs to understand how the futures market works.