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By mark7

Dec 15, 2013

Getting a Leg Up on Index Arbitrage Program Trading





 

Index arbitrage program trading activity can occur under certain market conditions. For example, if stocks are temporarily cheaper than futures, an arbitrageur will buy stocks and sell futures to capture a profit on the difference, or spread, between the two prices. By taking advantage of momentary disparities between markets, arbitrageurs perform the economic function of making those markets trade more efficiently.

Programed trades can produce sudden and possibly sharp market movements. Most likely, you have seen these types of moves on your charts. Knowing the likelihood of programed trading, this information can help you determine whether to initiate long or short positions in stocks, index futures, ETFs, and options.

How to determine when Index arbitrage program trading might occur

Buy programs occur when the futures market is over-valued relative to the stock market and consists of the index futures being sold and the stocks in the index being bought. Sell programs, the opposite case, occur when the futures market is under-valued relative to the stock market and consists of the index futures being bought and the stocks in the index being sold. Over-valued and under-valued conditions arise because trading in the futures and equities markets occurs independently. The key to determining these over or under-valued conditions is the arithmetic difference between the futures and the spot index (known as the premium).

Index premium can be easily charted in thinkorswim platform. In this example I am using the S&P 500. To chart the premium simply type in “/ES-SPX” as the symbol. The chart below shows the premium value on a 15 min chart.



Now that you have a graph for the S&P 500 premium, how do you determine when program trading might occur? You may have noticed the levels on the graph marked BA, BT, ST, and SA. These represent “Buy Active”, “Buy Threshold”, “Sell Threshold”, and “Sell Active”. So where do these levels come from and what do they mean?

There is a website that gives you this information for free. It’s called “inexArb” and the link is: http://indexarb.com/index.html

Here, you can get daily Index Arbitrage Program Trading Premium Values. Here is an example from Dec. 13, 2013:










For our example, I simply used the levels shown in the table to create levels in the graph. As you can see, you can create a graph for the NASDAQ and Dow Jones. Since these numbers are updated daily, you will need to adjust your chart daily.

The Sell/Buy Active and Thresholds are a calculated probability and are shown in as graphs on the website:



In the graphs above, the sell/buy active value occurs on the left/right side where the probability of a sell program approaches 100%. The sell/buy thresholds value occurs on the left/right side where the probability of a sell program is just greater than zero.

Please note that these levels are areas of “Probability of Programed Trading” and areas where programed trading might occur.

Following this information daily can be valuable to traders. The best way to use the chart is to watch the corresponding index for large buying or selling. If you are planning to use the information for trading, it is a good idea to use the “paper money” platform first.

*Check the full web page on indexArb for “Trading Guidelines”, and further information on calculation of SA, ST, FV (Fair Premium Value), BT, and BA.

Thanks- Mark