Program Traders and the Market Open

Futurestrade with high leverage in comparison to the stocks making up theindexes.  Buying 100 shares of the SPY(the ETF that tracks the S&P 500 index) would cost nearly $29,200 at thetime of this writing.  Even with 2:1margin, a trader would need $14,600 to maintain the position.  To trade one contract of the ES (the S&P500 eMini future), a trader only needs $6930. For an intraday trade, the margin could be as low as $500!

Thefirst half hour to hour of the equity markets can be very volatile. Sometimesit 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 andeven potential price reversals. This technique could be used for finding highlysuccessful intraday trade opportunities.

Takenote that the price of the futures is not the same as the index. This is doneon purpose. Buying index futures can be done to participate in the broad marketwithout having to buy all of the stocks individually.  Since a trader can put down smaller marginand trade futures in lieu of stocks, they could theoretically earn interest onthe money that they are not using had they bought the stock. The futuresexchanges attach a fair value to the future’s pricing in order to make thempriced similarly to the equivalent index. A futures trader will not receive dividends as would the stock or ETFtrader.  That dividend value must besubtracted from the interest added to arrive at the fair value.

FuturesFair Value = Interest available on the future contract until expiration minusthe 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 to get the data.

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

Thereare a group of institutional traders called program traders who have theircomputers set to recognize mispricing between the S&P 500 Index and theS&P 500 Futures.  When the mispricingoccurs, they buy the undervalued security (or the stocks making up the index)and sell the overvalued one.  This isknown as an arbitrage opportunity.

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

Lookingat the picture above, we can see the buy and sell thresholds with the fairvalues. Should the difference between the S&P 500 futures and the S&P500 index become greater than 2.82, some of the program traders will buy theundervalued stocks in the S&P 500 and sell the S&P futures to bring thetwo back in line. If a larger move on the futures pushes the price above whatthe index is trading at by more than 3.70, then all the programs traders shouldact and a sharp movement in the markets would result.

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

InTradeStation, you can chart the price difference between the S&P 500 indexand the S&P 500 futures.  This iscalled the premium and the symbol is $SPINX. If we look at the following chart of the premium along with the programtrading buy and sell thresholds drawn on the chart, we can identify the timeswhen these programs will move the markets.

Youcan see that within the first hour of the market opening, the premium spikedtoo high two times. Since the premium was too high the program traders actedand caused a rally in the equity market until the premium was near the 1.63target.  This gave a knowledgeable traderan excellent buying opportunity on SPY or even the individual stocks thatfollow the market.

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

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

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

Brandon Wendell can be contacted onthis link: Brandon Wendell

Be Fearful when Others are Greedy and Greedy when Others are Fearful

Using Weekly Stochastics to Time the Market