Most people have heard of the futures market, and it does get mentioned on news shows such as CNBC or MSNBC. A lot of people just don't understand what exactly 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 simply a bet on where an index will be as of a specified date in the future (hence futures market). That is not any different than having the opinion "I think GE will be 3 points higher in 3 months". Now imagine thousands or people, or even hundreds of thousands all betting on where GE will be in 3 months. Not tomorrow, 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. This time has a value - the more time you have to be right, the easier the call is. The market puts this time value into the price of the futures, each day that goes by a fraction of that is taken out. This 3 month time in this example is a fixed time, it does not scroll forward. So if the bet is the 31st of July, 2 weeks from now the GE bet would still be based on the 31st of July, but the time value associated with that bet would be a bit lower because there is less time left to be right (or wrong).

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 1 day, he gets a bonus of $40,000.00.  The more days you give him to be right, eventually, even just by random chance, he will be right.  So the time increase you might give him to be right would DECAY the value of the prediction.  Lets say you give him 1 month, but he is now only paid $10,000.00.  If you give him 3 months, that is only worth $1000.00 and so forth, this is a type of time decay.

This basic concept is then carried over to the stock indexes. Traders and investors place bets based on current and anticipated information and research for what they think the value of the index wil 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, that difference can be arbitraged between the two (cash and futures) since they trade separately. I can make a bet on the futures market (buying or selling) without doing anything with the cash index. On the same note, I can buy a large basket (or sell) of stocks in the index, without doing anything with the futures market. This give and take causes the 2 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 could place an order to sell the futures and simultaneously buy the component stocks and lock in 10 points of gain. In reality its not this easy, but this is the basic concept.  Anyone who wants to learn to trade needs to understand how the futures market works.