Indexes

• An index measures the performance of a large group of stocks or other investments. The Standard & Poor's 500, for example, represents a basket of 500 different stocks, and reflects the overall performance of the entire stock market. There are indexes on common stocks, bonds, commodities, currencies -- on just about any investment or instrument that rises or falls in value day by day.
  
  

Futures

• Futures contracts are tied to the underlying index. As the index rises or falls, the futures price moves in tandem. For the S&P 500 futures, the price quoted for a contract moves in increments of 10 cents, which represents actual contract value of $25. If the futures quote moves up $1, then the contract's value has risen by $250. There are four futures contracts each year, expiring in March, June, September and December.
  
  

Options on Futures

• An option on an index future is a contract to buy or sell that future at a certain level, within a set period of time. An option to buy is known as a call, while an option to sell is known as a put. Options carry a limited time value, and expire on the Thursday before the third Friday of the option month. A January 2011 S&P 500 $1,000 call option, for example, is a contract to buy the index future at the $1,000 level and will expire in January 2011. If the S&P future is below $1,000 at that time, the option expires worthless. If the future is above $1,000, the option is in the money, and the holder is paid whatever the option is worth.
  
  

Other Index Futures

• The rules on other index futures may be quite different from those covering the S&P 500. Contract size, price increments and delivery months may be different. Each future is tailored to the specifics of the instrument or commodity being measured. Investors should become familiar with the rules concerning the futures and options contracts before committing any money to the market.
  
  

Volatility and Premiums

• There are a few characteristics of index futures options that investors must remember. First, options that are closest to the underlying futures price have the greatest volatility. If the S&P 500 index is at $1,000, a $1,000 call option, for example, will move through a much greater range in price, as the index rises or falls, than an $850 call option. In addition, the farther out the expiration date, the higher the premium paid by the investor. As the expiration nears, the time value of the option falls, and the premium over and above the underlying value moves toward zero.