Program Trading and the Markets

While teaching a Professional Trader course in Minneapolis this week, I was demonstrating a technique where I can accurately predict the morning reversal of the S&P 500 Index due to arbitrage opportunities. In continuing the discussion with the class, I then realized that I had stumbled onto an odds enhancer for intraday trading under certain circumstances.

I will not give away the details of the initial trading opportunity that I teach since it wouldn’t be fair to my classroom and XLT students. But I will share the odds enhancer I found. 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 $15,000 at the time of this writing. Even with 2:1 margin, a trader would need $7500 to maintain the position. To trade one contract of the ES, (the S&P 500 eMini future), a trader only needs $3850. 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 4.94 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 3.72, 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 distance between them and the index to less than 2.81, 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 6.10, then some program traders will buy the futures and sell most of the stocks making up the S&P 500 index. 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 at the equity market open, the premium was too high. This caused a selloff in the equity markets until the premium was near the -4.94 target. Later in the day the premium moved again on the release of the Consumer Confidence number. This gave a knowledgeable trader several opportunities.

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.

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