Two weeks ago I was on Power Trading Radio with Merlin Rothfeld when a listener sent in a message about a “huge gap” in the E-mini S&P 500 futures contract. He seemed somewhat excited about it and was trying to figure out what news event had caused such a big move. He also asked if there was some type of gap play for the following morning. His call came in on Wednesday afternoon June 11 which happened to be the afternoon when all charts for the Stock Index futures on TradeStation were “rolling over.” And since he was using the custom continuous “unadjusted” chart, what the listener saw on the chart was the gap that’s created when the expiring month is no longer being plotted, and the new front month contract is the one being displayed on the chart.
Let me explain how this all works, and more importantly how this can be used to help you better analyze trades. First, you must understand that all futures contracts have a defined life span. In the example of the Stock indices, these expire on a quarterly basis. This means that since each contract will expire in different quarterly months the price of each contract is different. If we look at the two charts of the E-mini S&P 500 (ES) below we see the first one is the current front month of September and the other is the next month in the cycle which is December. Take note that the price on the September contract is 1949.75 and the price on the December contract is 1942.00 even though these captions were taken only seconds apart. The price discrepancy between the two contracts will narrow somewhat as we near the expiration date of the September contract; however, they will still vary up until the day of expiration.
Now that we understand the price differential in the various months we can explain how the custom charts work. The custom continuous chart is helpful in analyzing the futures markets on longer time frames because of the shelve life of the contracts. In other words, If a contract only trades for 18 months, then it’s obvious that if we wanted to look at the ES for a longer period than the life of the contract, we would need to link all the previous months together. In addition, if we wanted to have a true reflection of the price of that contract it would have to be “unadjusted” so that it wouldn’t be distorted by the price of every new contract being traded.
To keep it simple, the chart below displays the custom continuous chart of the ES that the listener was looking at when he called in. As you can see from the annotations, the gap was created because of the price discrepancy from the June to the September contracts.
So is this a legitimate price imbalance (real gap), or just an artificial gap created by the price differences between the two contracts. The answer is, most of the time it’s just an artificial gap, but there are instances where there may be a real price imbalance. The best way to verify a real price imbalance is to plot the actual contract by using the root symbol followed by the month and the expiration year of the contract. In this example it would be ESU14 which should be used (if the data is clearly visible), if not, then the custom charts should be deployed to get true price levels beyond the life of the contract.
Perhaps this clarifies some of the questions we often get about the gaps that are created on rollover, and hopefully help you make better trading decisions in the future.
Until next time, I hope everyone has a great Fourth of July weekend.