Programming Your Odds

Online Trading Academy Article of the Week

by Brandon Wendell, Online Trading Academy

While teaching a Professional Futures Trader course in Kansas City several weeks ago, I was demonstrating a technique that can predict the morning reversal of the S&P 500 Index and the related futures contracts due to arbitrage opportunities. This is a technique that I have used successfully for years when I traded stocks. It can also be used as an odds enhancer for intraday trading under certain circumstances.

In this article I will discuss the overall use of the tool for increasing your chances for successful trading. In next week’s follow up article, I will detail the trading technique I use in order to take advantage of this arbitrage.

For those who may not know, 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.

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 $19,700 at the time of this writing. Even with 2:1 margin, a trader would need $9850 to maintain the position. To trade one contract of the ES, (the S&P 500 eMini future), a trader only needs $5060. Or much less if it is an intraday trade.

Since a trader can put down smaller margin and trade futures in lieu of stocks, they could earn interest on the money they are not using by buying stock. Well, maybe when the US banks actually pay interest again. So the futures exchanges attach a fair value to the futures in order to make them priced similarly to the equivalent index. Additionally, a futures trader will not receive dividends as would the stock or ETF trader. That dividend value is subtracted from the interest 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.

As you can see from the fair value, the S&P Futures should be trading 6.96 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. Should the difference between the two become less than 0.80, 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 3.79, then all of 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. If the price gap between the two grows greater than 11.66, 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 15.15 below the price of the index, then all of 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 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.

You can see that early in the morning about an hour after the equity markets open, the premium was too low. This caused a rally in the equity markets until the premium was near the -6.96 target. This gave a knowledgeable trader an excellent trading opportunity since price was also at demand. Note that the $SPINX chart is on central time while the SPY chart is eastern.

On any given day, when you are watching your stock 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.

We must not forget that we need to center our trading decisions on 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.

Looking at the following chart, you can see that the S&P 500 futures (on top) trades for 23 hours a day, while the S&P 500 index is only open from 9:30am EST to 4:00pm EST. That means that the futures can and do respond to news that is released before the stock open or to European and Asian market movements.

Checking the fair value on www.indexarb.com just before the open for the stock market tells me that the futures should be trading below the index by 5.21.

Since the futures rallied sharply in the early morning hours, they were trading well above their fair value. The index will gap slightly but not all of the way to where it will be above the futures by the fair value amount. That means that it should rise sharply when the bell rings. Adding the fair value to the futures trading price tells us the target the index will look to achieve on the open. Remember that the futures will also move, so the exact target will be when the two are separated by fair value.

Since the SPY will gap on the open as it is tradable in the pre-market hours, I instead look to stocks that are gapping opposite of the market’s movement in order to find a trading opportunity. There are many resources for finding gapping stock. I chose to use the Nasdaq’s website to see the most declined stocks in the pre-market.

I usually only look to trade the stocks that are priced above $15 and do not trade the ETF’s for this technique. You can see that there are three such stocks. I also looked at ACHN since it was trading close to $15.

These stocks that were gapping down were likely to be pulled up by the extreme bullishness of the broad markets at the open. They make better trading candidates when they are gapping down into demand zones as well.

When the opening bell rang, the S&P index gapped up slightly and then quickly rallied for three minutes until it was trading above the futures by approximately 5.21, the fair value. Notice that the futures sold off slightly as well. That is why the initial target for the index was not met.

Notice how the stocks quickly rallied when the market was moving up. Shortly after the market stalled, they started to fall as well. This time the market rallied for three minutes. The stocks were carried by the bullish momentum and rallied for about five minutes from the open. A trader could have bought the stocks at the open, provided they were gapping into demand, and sold them for a quick profit when the S&P 500 index stalled.

The same technique would be applied when the index must drop to meet up with a down futures market. A trader would look for stocks that were gapping up into supply and short them until the index dropped sufficiently.

There are no guarantees in the markets and this technique is, of course, not going to work all of the time, However, it is a phenomenon that occurs on a regular basis and an experienced trader can take advantage of it and trade alongside of the program traders.