Lessons from the Pros

Stocks

Program Traders and the Market Open

The first half hour to hour of the equity markets can be very volatile. Sometimes it seems like prices are fluctuating wildly with no rhyme or reason. However, there is a technique that could help you predict the morning price movement and even potential price reversals. This technique could be used for finding highly successful intraday trade opportunities.

Futures trade with high leverage in comparison to the stocks making up the indexes.  Buying 100 shares of the SPY (the ETF that tracks the S&P 500 index) would cost nearly $29,200 at the time of this writing.  Even with 2:1 margin, a trader would need $14,600 to maintain the position.  To trade one contract of the ES (the S&P 500 eMini future), a trader only needs $6930.  For an intraday trade, the margin could be as low as $500!

Take note that the price of the futures is not the same as the index. This is done on purpose. Buying index futures can be done to participate in the broad market without having to buy all of the stocks individually.  Since a trader can put down smaller margin and trade futures in lieu of stocks, they could theoretically earn interest on the money that they are not using had they bought the stock. The futures exchanges attach a fair value to the future’s pricing in order to make them priced similarly to the equivalent index.  A futures trader will not receive dividends as would the stock or ETF trader.  That dividend value must be subtracted from the interest added to arrive at the fair value.

Futures Fair Value = Interest available on the future contract until expiration minus the dividends to be paid on the stocks until the expiration.

The fair value only changes once a day when the equity market closes.  That is when a stock would go ex-div and pay out a dividend and also when there is one less day of interest until expiration.  There are plenty of sites that show you the fair value number. I tend to check www.indexarb.com to get the data.

Chart showing information for calculating Fair Value on the S&P 500 futures index.

Due to the market forces of supply and demand and price movement, the relationship between the index futures and the indexes themselves will change.  While there is a fair value assigned to the futures, they may not be trading at that value from time to time.

There are a group of institutional traders called program traders who have their computers set to recognize mispricing between the S&P 500 Index and the S&P 500 Futures.  When the mispricing occurs, they buy the undervalued security (or the stocks making up the index) and sell the overvalued one.  This is known as an arbitrage opportunity.

As you can see from the fair value, the S&P Futures should be trading 1.63 points below the S&P 500 Index for the entire day.  The buy and sell thresholds tell the program traders when the two are mispriced and ready for an arbitrage opportunity.

Chart showing index arbitrage program trading premium values

Looking at the picture above, we can see the buy and sell thresholds with the fair values. Should the difference between the S&P 500 futures and the S&P 500 index become greater than 2.82, some of the program traders will buy the undervalued stocks in the S&P 500 and sell the S&P futures to bring the two back in line. If a larger move on the futures pushes the price above what the index is trading at by more than 3.70, then all the programs traders should act and a sharp movement in the markets would result.

The opposite would occur should the difference between the S&P index and the futures become too great on the downside.  If the price gap between the two becomes smaller than 0.22, then some program traders will buy the futures and sell most of the stocks making up the S&P 500 index.  If the price of the futures drops more than 0.85 below the price of the index, then all the program traders should move in and buy futures and short the stocks.  This will result in a larger move in both the index and the futures.

In TradeStation, you can chart the price difference between the S&P 500 index and the S&P 500 futures.  This is called the premium and the symbol is $SPINX.  If we look at the following chart of the premium along with the program trading buy and sell thresholds drawn on the chart, we can identify the times when these programs will move the markets.

$SPINX five minute chart

You can see that within the first hour of the market opening, the premium spiked too high two times. Since the premium was too high the program traders acted and caused a rally in the equity market until the premium was near the 1.63 target.  This gave a knowledgeable trader an excellent buying opportunity on SPY or even the individual stocks that follow the market.

$SPINX five minute chart showing the market opening

On any given day, when you are watching your stock or the SPY approaching a supply zone and are trying to decide whether you should sell or short the level, look at what the premium is doing.  If it is approaching the lower levels or sell thresholds, then you should have more confidence that the level will hold.  If you are looking at a demand zone on your stock and the premium is moving up to or beyond the buy threshold, you should have a higher confidence of the demand zone working.

I decided to take it one step further and placed a Bollinger Band set to 20 periods and an exponential moving average on the premium chart.  I noticed that when the band was pierced, it often corresponded with an immediate change of trend direction in the SPY ETF.

$SPINX five minute chart showing bollinger bands

We must not forget that we need to make our trading decisions on Online Trading Academy’s Core Strategy of supply, demand, and trend.  So, while the premium chart with Bollinger Bands is not the holy grail of technical analysis, it is something that a trader can use as a decision support tool.

There are many other tools and other curriculum designed to help you make informed trading decisions at Online Trading Academy. Be sure to visit your local center today or visit us online.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.