Part 17 (2/2)
Traders typically look for the difference in the futures price and fair value to exceed $5 or fall below $5 to trigger a trade, but compet.i.tion may cause some traders to jump ahead of that threshold. Once a program trade has been set, stocks and futures should converge within a short time, but the worst-case scenario is that they converge at delivery. The sooner they converge, the sooner traders have their investment back and can use those funds for another trade. If stocks and futures take a long time to converge back to equilibrium, the traders are effectively losing money.
Volatility plays an important role in triggering index arbitrage opportunities. Volatility causes all markets to move quickly, often independent of one another. At the same time, volatility attracts volume. The combination a.s.sures that index arbitrage will come into play.
The S&P is traded in many ways, and all of them are subject to a similar arbitrage to keep prices in equilibrium. There is also a large selection of ETFs that mimic the S&P cash price. The best known of these is SPY (”Spyders”), traded on NASDAQ, but a wide range of leveraged funds are offered by ProShares, ProFunds, Rydex, iShares, and other financial companies.
There are many variations on index arbitrage. It might be possible to sell S&P futures and buy the SPY ETF, or buy S&P futures and sell SPY, avoiding all the short-sale issues. Program trading is a big business, and professionals hold a so-called book of positions in such a way that short-selling can be done instantly. The elimination of the uptick rule and the move to trading pennies instead of eighths have facilitated program trading. The negatives are that, if the S&P drops more than a fixed percentage in one day, all program trading is halted, an awkward situation if you're in the middle of a trade. Also, compet.i.tion has caused some traders to select a smaller set of stocks to represent the S&P futures in order to reduce costs and expedite the process. They might set the arbitrage with marginal profit expectations just to enter sooner than other traders waiting for bigger opportunities. It is a clear case of compet.i.tion improving the spread and liquidity of the market.
How Can We Partic.i.p.ate?
If we're going to partic.i.p.ate in this arbitrage, then the practical answer is to choose a smaller set of markets that has an index that can be traded. Of the futures markets, that would be the DJIA, which has 30 components. Tracking the fair value of the Dow futures would be a straightforward process on a spreadsheet. Each day you would change the number of days to delivery and get a number that can be used all day to monitor differences in the cash and futures prices.
On even a smaller level, you can calculate the fair value of single stock futures and find a trigger point that makes that a profitable trade. While others are out there looking at the same opportunities, taking a slightly smaller profit and a slightly bigger risk may give you an edge.
About the Companion Web Site.
This book includes a companion web site, which can be found at /go/alphatrading (pa.s.sword: alpha). There you will find a series of six Excel spreadsheets: 1. An Excel spreadsheet showing the calculations needed for creating a pairs trade made with two stocks plus trading signals. You can enter your own signal threshold levels and costs to test the results.
2. An Excel spreadsheet showing the calculations needed for creating a pairs trade using two futures markets plus the trading signals. You can enter your own signal threshold levels and costs to test the results.
3. An Excel spreadsheet showing the calculation of the stress indicator.
4. Two more Excel spreadsheets similar to (1) and (2) showing pairs calculations using the stress indicator.
5. An Excel spreadsheet showing the calculations needed for a crossover pairs trade, one stock and one futures market.
6. An Excel spreadsheet showing a simple portfolio of pairs (or any a.s.sets), including volatility-adjusting.
About the Author.
Perry Kaufman has 40 years of experience in financial engineering and hedge funds, and is well known for his role in algorithmic trading. Beginning as a rocket scientist in the aeros.p.a.ce industry, he worked on the navigation and control systems for the Gemini project. Since 1971, Mr. Kaufman has specialized in the development of fully systematic trading programs in derivatives and equities, as well as risk management and leverage overlays. During his career, Mr. Kaufman headed trading operations for large firms and has partnered three successful hedge funds. He is the author of New Trading Systems and Methods, Fourth Edition (John Wiley & Sons, 2005), A Short Course in Technical Trading (John Wiley & Sons, 2003), and other books and articles that have gained worldwide acclaim.
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