If you watch the early morning business shows on TV, chances are, you’re going to see a segment that reports the status of “pre-market futures”.
Usually, they will give an indication of how the stock market will open when the trading begins at 9:30 am EST.
Financial experts usually evaluate the stock index features for pre-market futures before the start of the day’s stock trading.
They will normally link the futures contracts’ quotes to the S&P 500, a stock index of large and medium-size companies.
While futures and stocks trade separately, the price of the index (relative to the value of index futures) provides a strong hint on how the stock market’s early behavior will show.
Understanding Futures Contracts
A futures contract works as its name implies. It is an agreement for the future delivery of a specified amount or volume of the underlying asset.
The contract for these futures assets (for example, a stock index) will carry a range of contract dates.
Typically, equity futures contract has a range of one year which they break down into quarterly contract dates.
It also carries several annual contract dates for the benefit of traders who want to take a long-term position on a stock index.
If an investor holds an equity futures contract until the closing date, the final value of the futures contract will be dependent on the actual stock index value.
The buy or sell date is always set in the future. Let’s say a buyer agrees with a seller to purchase 10 shares of stock at $20 each, two weeks from today.
When the two weeks are up, the buyer must pay the agreed price (which is $200) regardless of how much the said stock is currently selling for.
Futures Contracts Trading: How It Works
Normally, the buyers and the sellers will use the price they expect the future market will be as their contract price.
This system of pricing can benefit the seller or the buyer depending on how the market plays out.
If the futures price is less than the actual trading price, the seller benefits (Since he has already sold the contract for a higher price). If the agreed price is more than the actual trading price, the buyer benefits. (Since he has already bought the contract for a lower price)
The final (or ‘settlement’) price of the contract on the close of its expiration day will be exactly equal to that day’s closing price of the index.
Stock Market Futures
Under a stock index futures contract, a trader has to absorb any profit or loss on the specified stock index during the period that he is holding the contract.
The Difference Between Pre-Market Futures and Stock Markets
It is correct that stock index futures contracts trade against the values of the specified stock indices. However, there is no direct link between the two markets or of futures and stocks.
Stocks get their values according to how traders bid and ask prices – and the value of their underlying indices. The pre-market futures prices only indicate at what level the stock market might open.
“The Spread” – How It Works
Stocks in the S&P 500 normally trade the whole day until the market closes at around 4 pm EST.
Traders peg the closing value of the index on the final trade of each component stock of the index. Once determined, this index value will remain unchanged until the market opens again the next trading day at 9:30 am EST.
Take note that for CME index futures, it closes twice during a 24-hour cycle. The first close happens at 4:15 pm EST.
The difference between the futures afternoon closing price and the stock market closing index is what is known as “the spread”.
Futures trading will resume at 4:45 pm and goes on all night long. When 9:15 am comes EST the following day, the second close occurs.
After that, futures begin trading again at 9:30 am or fifteen minutes later, simultaneously as the stock market opens for trading.
The “Fair Value”
Futures price is directly dependent on the current supply and demand for the futures contract.
The unique thing is that because futures continue trading after stocks close, the futures price can change invariably throughout the night as new information comes in.
Aside from this “real-time” futures price is what they call the “fair value”, which help us to forecast the future price.
The fair value is a result of a statistical complex calculation that factors in the last closing value of the index, interest rates and time before the contract expires.
What fair value does is give the theoretically “correct” size of the spread which does not change until the index’s next closing price comes in.
Pre-Market Indications – Example
To illustrate, let’s say the S&P 500 index closed the day before at 1470 while futures closed at 1472 which means that the spread is +2.00 (1472 minus 1470).
Suppose that they computed for today’s fair value reading at +6.00 which implies that the “correct” final settlement price of the front-month contract is 1476 (or 1470 plus 6).
If the futures contract climbs another 4.00 points overnight to 1476, then its price is exactly at fair value and therefore does not provide a directional indication regarding the stocks.
However, if the futures contract only gained 2.00 points overnight the price climbs to just 1472.
In this case, the futures are up relative to their previous close but are down relative to the fair value. And because futures are below fair value, analysts will say that the pre-market indication is towards a weaker stock market opening.
Pre-Market Futures: The Data is Critical
The pre-market is awash with information and many are electronic data and other data related to futures contracts.
Traders rise and fall because of these data such that on each trading day, throughout the day, they try to keep abreast of information that becomes available at the moment.
As an investor, it is a good discipline to check the economic calendar every morning before the start of trading.
You should try to get out of all positions at least one minute before major data are made public and avoid taking new positions within five minutes before a data release.
Data releases can cause price gaps and you might have a hard time controlling risk. As soon as they release the data, day traders immediately resume watching for valid trade setups.
During the pre-market, it is important to be on the alert for news releases. There are more data releases during the pre-market than during regular trading hours.
And since there is a lower volume in the pre-market, the data releases tend to have a larger effect than they would normally have for the higher volumes.
Here’s the point: if you trade in the pre-market, always keep your eyes peeled and ears open. Just watch for data releases on the economic calendars and avoid holding positions during the release.
Predict Stock Price by Pre-Market Future: Is it possible?
It is not unusual to meet investors and analysts who use pre-market futures to predict how a stock will fare once trading starts.
After all, the stock index futures price is the pre-market futures average and it closely reflects what price the stock might open at.
Of course, that is not always the case because in some cases, the stock index futures price does not correlate with the stock’s actual opening price.
There will be times when the two values will vary very far from each other. Aside from this, the stock’s price may fluctuate before the market closes for the day.
Remember that the stock index future price is not an accurate representation or measure of a stock’s trading performance for the day.
Pre-Market Trading Hours and Costs
In the United States, the normal investing business hours are from 9:30am and 4:00 pm ET, Monday through Friday.
However, take note that in the NYSE, pre-market stock trading happens only from 8:00 am to 9:30 am or a mere 1.5 hours instead of 6.5 hours. The Nasdaq market begins their pre-market trading at 7:00 am.
This means that you will have to give yourself an early start to do business although not a lot of traders participate in pre-market trading compared with normal business hours.
The advantage is, if something monumental happens during that time that may affect prices, you’ll be the among the first traders to use the information to your trading benefit.
There is no uniform set of cost and procedure for pre-market trading; they will vary among brokerage firms.
A good number of them, including Scottrade and TD Ameritrade, simply charge regular commissions for pre-market transactions.
Others will collect a special fee schedule while some may impose a surcharge, such as E*Trade, which charges an additional $0.05 per share for extended-hours trade.
You can find out about your broker’s specific pre-market policy by looking at their website or by directly inquiring with their customer service.