Asset prices are usually quoted in two different ways: spot or futures. Spot prices are the current price of the asset if purchased today. Futures prices are the estimated price of the asset sometime in the future. An index is used to track a group of assets or stocks for a particular market or segment of the market. Investors use index futures to speculate on the future direction of a particular index.
There are many different types of indices. Some indices track bond prices and others track stock or commodity prices. Indices can track everything from a particular slice of industry to a certain management type. They all serve as a benchmark for one particular segment in the market.
The MSCI World and S&P Global 100 are two indices which track large global companies. The Japanese Nikkei 225 and the British FTSE 100 are examples of two national indices which track prices by the nationality of the companies in the index. The Wilshire 5000 Index represents the stocks of almost every U.S. stock traded across several different exchanges. Specialized indices such as the Wilshire U.S. Real Estate Investment Trust (REIT) track the REIT sector of the market. Another example of a specialized index is the Morgan Stanley Biotech Index.
Index futures contracts are usually standardized contracts. They allow investors to bet on the direction of a particular segment of the market in the future. For instance, if an investor believes large-cap stocks will be going up in the future they can purchase index futures in an index which tracks large-cap stocks.
One of the most commonly quoted indices is the S&P 500. It represents 500 large-cap stocks across different industries. If a portfolio manager needs to mitigate the risk of a portfolio going down, he or she can sell index futures contracts which are connected to the S&P 500. In this way, if the stocks in the portfolio go down because of changes in the larger market, the value of a short position in S&P index futures contracts will go up.
Portfolio managers also use index futures to gain increased exposure to certain movements in the general market. For instance, in many betting games or games of chance, bettors can bet on the possibility of multiple events occurring at the same time. For example, imagine that a random number will be pulled out of a hat. Guessing the exact number and guessing if it will be odd or even are two possible bets that can be made on the same event. If the bettor bets the number will be ten and even, the bettor wins twice if ten is selected.
Portfolio managers use this same logic when purchasing or selling shares in a particular index. If the stock goes up, the index value might also go up resulting in the opportunity to make a profit twice.