Dow Futures are a reasonable thing not to know about if you’re not well-versed in investing. Essentially, a Dow Future is a contract between two parties in which they bet on the direction of the Dow Jones Industrial Average (DJIA), an index of 30 major U.S. companies. Futures aren’t quite as simple as other investment options like stocks, bonds and mutual funds. If you’re a more advanced investor or a have a higher tolerance for risk, however, they may be worth considering for your portfolio.
What Are Dow Futures?
Dow Futures are contracts between two investors that are traded on an options exchange. The exchange serves as the intermediary between the two individuals or institutions. The two parties in a futures contract basically bet on where the Dow Jones Industrial Average (DJIA), one of the most widely used and reported on stock indexes in the United States, will trade on a specified day. This day is known as the “final settlement date.”
Early in the morning, you’ll see news reports about how Dow Futures are trading. This helps predict how the market will open. Dow Futures begin trading on the Chicago Board of Trade at 7:20 a.m. Central Time (8:20 a.m. Eastern Time), which is an hour and 10 minutes before the market opens.
How Dow Futures Trading Works
Generally, you derive the value of a Dow Futures contract by multiplying the size of the DJIA by 10. If the DJIA is trading at 10,000, the contract is worth $100,000. There are also contracts available where the multiplier is five or 25, which would also impact the potential payout or loss.
When two parties agree to a Dow Futures contract, one party is betting that the value of the DJIA will go up while the other is betting that it will go down. On the final settlement date, whoever is wrong must pay the other party based on the value of the Dow. The person selling the future makes money if the index goes down, while the person buying the future makes money if it goes up.
Consider a futures contract built around a DJIA value of 10,000 using the standard multiplier. Investor A sells the contract to Investor B. On the final settlement date, the DJIA is trading at 10,500. Using a multiplier of 10, this means that Investor A owes Investor B $5,000. On the flip side, if on the final settlement date the DJIA is worth only 9,200, Investor B owes Investor A $8,000.
Why Would You Use Dow Futures?
When you buy a single stock, you are essentially placing a bet that you think that stock will go up in value, thus allowing you to sell it for a higher price than you bought it. Or, if you take the short position on a stock, you are betting the price will go down, allowing you to buy it for a lower price than you sold it.
If you think the whole market is about to fluctuate — particularly if you think the market event will be big enough to drive up or down the price of all or almost all of the biggest companies on the market — then buying or selling a Dow Future lets you bet on the entire market. This gives you the potential to make way more money than if you simply bought shares in individual stocks.
Of course, if you are wrong, the opposite is true as well. You have the potential to lose a lot more money than if you simply bought shares in individual companies. Also, you have a legal obligation to pay out if you lose. This is not true for stock purchases. You can’t just wait and see if your prediction ends up coming true as you could if you bought shares of a company or even took a short position.
Who Should Use Dow Futures?
Dow Futures can certainly be a useful tool in the arsenal of an investor, but they are probably best reserved for veterans of the stock market. People who have studied the market and understand what causes fluctuations are the most likely to have a good grasp on what the DJIA will do in the months ahead. Thus, they are the most likely to make an accurate prediction about what the Dow will look like on the final settlement date. Dow Futures probably aren’t the best choice for newer investors.
Similarly, this is likely a tactic best used by investors who can swallow a potentially big loss. Whoever loses the contract must pay out. Depending on the change in value of the DJIA and the multiplier, the payout could be steep. If you don’t have a high risk tolerance when it comes to investing, less risky investments may make more sense.
The Bottom Line
Dow Futures are an investment strategy in which two parties bet on where the Dow Jones Industrial Average will be trading on a certain date, known as the final settlement date. The contract is legally binding and whomever is wrong must pay the other party. You can calculate the amount owed by multiplying the amount of the increase or decrease in the DJIA by a predetermined multiplier, generally 10.
Investors use Dow Futures to exploit what they see as potential big swings in the market. Because they’re risky, Dow Futures are generally best for experienced investors who could absorb a potentially big loss.
- A financial advisor can answer questions on all sorts of investing topics, including Dow Futures. SmartAsset can help you find the right advisor for you with our free financial advisor matching tool. You answer a few questions about your finances. Then, we match you with up to three advisors in your area, all fully vetted and free of disclosures. You get a chance to talk to each advisor and make a decision about how you want to proceed.
- If you’re more interested in traditional investing, asset allocation is key to building your portfolio. Figure out how you should divvy up your portfolio with SmartAsset’s asset allocation calculator.
Photo credit: ©iStock.com/Fabrice Cabaud, ©iStock.com/guvendemir, ©iStock.com/Nikada