Tag: top brokerage firms

Stock Index Education Home Page

 Understanding Intermarket Spreads

A trader can spread between two highly correlated futures contracts of similar but different types. This is known as an inter-market spread.

In the financial futures markets, inter-market spreads can involve trading in highly correlated contracts of different types. For example, you could take a spread position between two different stock indexes by buying one and selling another. If you’re bullish on the technology sector versus the broad market, you could buy the NASDAQ futures and sell the E-mini S&P.

The point of entering into an inter-market spread is to trade on the differences in the two respective contracts rather than the direction of the overall market. These types of trades are sometimes referred to as relative value trades.

Risks and Opportunities

Spread trading does involve risk, and in fact you can lose money on both sides (positions) of the spread. However, spread trading offers unique opportunities that differ considerably from outright long or short positions.

In order to utilize perceived spread opportunities, traders must know the economic fundamentals of the market; this includes a seasonal and historic knowledge of price patterns. Traders must be able to recognize the potential for widening or narrowing changes between contracts and to make that spread change work in their favor.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

Stock Index Education Home Page

Trading Opportunities

Due to their wide acceptance as benchmarks and deep liquidity, Equity Index and Select Sector futures can be used by risk managers and traders for a variety of purposes. These flexible products can be employed in numerous trading and hedging strategies.

Possible Trading Strategies

Examples of possible trading strategies include:

Outright bull/bear directional trades
Beta replication/beta adjustment
Portable alpha
Conditional rebalancing
Spreads
Sector rotation

Index Spreads

Another possible trading strategy is an index spread. A spread is the simultaneous purchase and sale of two futures contracts. An index spread is a common and effective trading strategy. The strategy is designed to express the relative value between index contracts rather than an outright market direction bias.

How Spreads Are Used

Outright long or short positions in Equity Index futures can be easily established to reflect a trader’s point of view regarding that index’s next directional move or trend. For example, if a trader believes that the S&P 500 Index is over-valued and will trade lower soon he may sell E-mini S&P 500 futures to express that view.

Asset managers that want to use Equity Index futures to replicate exposure to an index may buy futures contracts and use the residual capital for cash management purposes or alpha producing tactical strategies.

Another possible trading strategy is an index spread. Consider an index spread, specifically, spreading the NASDAQ-100 to the S&P 500.

Advantages of Index Spreads

Because spread trades involve both a long and a short position in highly correlated contracts, they are generally viewed as less volatile and therefore less risky than an outright position in a single contract. Additionally, since spread positions generally reflect lower market risk, there are lower margin requirements.

Example of an Index Spread

Let’s look at an example of a possible equity index spread. The NASDAQ-100 Index is heavily weighted to the technology sector. The S&P 500 Index, by contrast, is recognized as having a broad, diversified constituency and represents the broad market. What makes this type of trade possible is both of these indices, while slightly different, have a high degree of price correlation. In other words, they tend to trade directionally in a similar pattern.

In order to construct this spread, we must first calculate a Spread Ratio. The spread ratio is defined as the notional value of one index future divided by the notional value of another.

In this case, we will divide the notional value of the NASDAQ-100 futures by the notional value of the S&P 500 futures.

HOW THE TRADE MIGHT PLAY OUT

A portfolio manager (PM) believes the tech sector is at risk versus the broad market. He is willing to express this opinion with a $100 million equivalent risk position, leading the PM to take the following actions:

The PM sells the E-mini NASDAQ-100/E- mini S&P 500 spread. First calculating the spread ratio, the notional value of the NASDAQ Index equal to 4711.50 x $20 dollars, or $94,230 per contract divided by a notional value of E-mini S&P of 2093.00 x $50 or one $104,650 per contract. Our spread ratio, then, is equal to $94,230 ÷ $104,650 per contract. This comes to 0.9004 E-mini S&P 500 futures for every one E-mini NASDAQ-100 futures.

Divide the notional value of the E-mini NASDAQ-100 futures into the $100 million dollar risk assumption, and you get 1061 NASDAQ-100 futures contracts. Applying the spread ratio of 0.9004 to 1061 results in an equivalent E-mini S&P 500 futures position of 955 contracts. Since the trader believes the tech sector is overvalued versus the broad market, he will sell 1061 E-mini NASDAQ futures and simultaneously buy 955 E-mini S&P 500 futures.

At this point, the trader believes the valuations have normalized. Now, he simply unwinds the spread by executing orders opposite to the original trade. He would do this by purchasing E-mini NASDAQ futures and selling the E-mini S&P 500 futures.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

Stock Index Education Home Page

The idea behind risk management is to ensure you will not incur losses greater than your risk tolerance. In practice, it means balancing risk versus reward and then making an informed investment decision.

A key component of risk management is hedging. Hedging is like insurance; you hope things go as planned, but if they do not, then what? Hedging can provide a means of protection for unplanned or negative events.

Where Notional Value Comes In

There is an old expression, “you can’t manage what you can’t measure.” Risk managers and traders can use Equity Index futures to help manage their equity index risk. It begins with understanding the notional value of the Equity Index futures contract. The notional value of a futures contract represents that contract’s financial equivalent value. For Equity Index futures, it is calculated:

Notional value = price of futures contract x contract multiplier.

In the case of the E-mini S&P 500 futures that have a fixed multiplier of $50, it might look like this: 2185.00 (futures price) x $50 = $109,250 per contract. The notional value represents the financial value of the contract at that price level.

Using Notional Value as Part of a Hedging Strategy

Traders use notional value to compare the current value of the futures price to other futures contracts or highly correlated physical positions. When calculating a hedge ratio, traders and risk managers would want to compare the value of the instrument of portfolio at risk versus the relative value of the futures contract.

EXAMPLE

For example, assume the E-mini S&P 500 futures are priced at $2185.00, which results in a notional value of $109,250. Now consider a portfolio manager with a $10 million S&P 500 equity risk position. Suppose she wants to reduce her exposure to the S&P 500 index by 10%. She could utilize E-mini S&P 500 futures by selling futures in a ratio based on the notional value of the futures contract.

Hedge ratio = value at risk ÷ notional value of futures contract

In this case, 10% of $10 million is $1 million that needs to be hedged. To calculate the equivalent futures contracts needed to hedge this position, divide $1 million by the notional value of the futures contract, which is $109,250. This equals 9.15, or the equivalent of nine E-mini S&P 500 futures contracts.

Say the S&P 500 index goes down by 3%, from 2185.00 to 2119.50, a drop of 65.5 index points. The portfolio loses 3% or $300,000. If the manager sold nine futures contracts, she would have gained $29,475. This is derived as follows: 2185.00 – 2119.50 = 65.50 index points: 65.50 index points x $50 per point x 9 contracts = $29,475.

The portfolio manager’s net result is $300,000 minus $29,475 = $270,525 or a 2.7% loss rather than 3.0%. She has effectively reduced her losses by 10% adding value to her shareholders.

How We Can Help

We trade Equity Index products providing risk-management tools that serve to assist equity portfolio managers in even the most challenging market environments. By providing deeply liquid, actionable prices on benchmark index futures and options, we can provide risk managers and traders with the tools to implement their hedging and tactical trading strategies.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

 

Stock Index Education Home Page

How to Roll an Equity Position Forward

All futures contracts have a defined expiration and a specific delivery date. So part of managing your futures position is knowing what to do when your contracts approach expiration.

Most traders are in the futures markets to profit from variations in price movement. They do not want a cash settlement or a physical delivery when their contracts expire, so only a small percentage of trades actually go through delivery.

To avoid delivery, traders offset their position prior to expiration. One way to do this is by liquidating.

Roll a Contract Forward

A trader rolls their contract forward when they wish to exit an established position=, which means offsetting your current position and establishing a new position in a forward month. Traders do this when they do not want to give up their market exposure when the contract expires.

To illustrate, as futures contracts expire they roll off the board. So a trader with exposure in a March contract has to get out of the March position and move their interest into June.

EXAMPLES

There are two ways to roll a contract forward:

To leg in, which means selling the March contract, then buying a June contract in two separate transactions

Initiate a spread, or position roll, by executing the closing order of the March contract and the opening order of the new June contract simultaneously

Unlike legging in, when you initiate a spread, there is no time gap in between the two orders. That is important because a time gap can result in slippage, the potential loss from market moves between the closing and opening orders. Using the roll to move positions forward in a single transaction minimizes the chance of slippage.

Now that you know how to roll your position and manage expiration, you should feel much more confident trading futures.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

Stock Index Education Home Page

Equity Index Basis

Basis is the difference in price between the futures contract and the spot index value. We generally quote Equity Index futures basis as the futures price minus the spot index value.

Why does basis matter?

Basis matters because Equity Index futures are not an asset. They do not convey the same rights of ownership and income possibilities that an index of physical shares of stock possess.

Consequently, equity index futures cannot be expected to trade at the same price level as the spot or cash value of the associated stock index.

About Cost of Carry

The basis of an equity index futures contract versus its underlying spot index may be positive or negative, depending on dividend income and financing cost rates.

To fully understand the basis, it is necessary to understand something called cost of carry. There are a number of costs associated with having an investment position. Factors may include financial costs, such as interest, and economic costs, such as opportunity costs.

As previously mentioned, because Equity Index futures are not an asset, they don’t convey any rights of ownership, such as receiving dividend payments. However, the financial value, or opportunity cost, of those dividends is accounted for in the price of the Equity Index futures contract.

When short-term interest rates (represented by finance charges) are lower than the dividend yields on the spot index, the cost of carry is said to be positive.

EXAMPLE ONE

If current short-term rates are at 0.65% and the dividend yield on the S&P 500 index is roughly 2.00%, the cost of carry would be positive.

This is because the dividend income stream at 2.00% would be greater than the cost of finance at 0.65%. The futures price must reflect this economic reality by discounting in price versus the spot index.

EXAMPLE TWO

Say that on a given day, E-mini S&P 500 futures for expiration in September 2016 (ESU6) were quoted at a price of 2187.75 while simultaneously the S&P 500 spot index was quoted at 2188.51 points. The difference (2187.75 – 2188.51 = negative 0.76 index points) is the basis. The futures are trading at a discount to spot. This is due to positive carry.

The price spread, or basis, between futures and spot includes a function of the time value of money. That is, the value of the dividend income discount gets smaller and smaller as the contract approaches expiration. It disappears entirely as futures and spot settle to the same figure.

Summary

Basis is the price difference between cash (spot) and futures price.

In the case of equity index products, there is a cost of carry consideration that determines whether the futures price trades at a discount or a premium to spot.

Finally, be aware that the basis valuation is the result of the finance charges versus the dividend income. It will be different depending on the index or sector futures contract under consideration.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

 

Stock Index Education Home Page

Who Trades Equity Index Futures?

Equity index products are used by a wide range of industries and groups, including portfolio managers, endowments, asset managers, mutual and ETF funds, and self-directed traders. CME Group offers futures and options products on multiple equity indices to accommodate different market participant needs.

Portfolio Managers

Portfolio managers (PMs) are responsible for creating and managing equity market risk for their clients. Equity Index futures lend themselves to a variety of risk management overlay strategies to either reduce risk or enhance returns. Some of these strategies may include:

Beta replication
Asset rebalancing
Sector rotation

Funds

Endowment, pension and mutual funds generally take a long-term investment view. They may focus a substantial part of their investments in equity markets to help achieve their long-term capital growth objectives.

Certain Equity Index futures strategies can be applied by risk managers to efficiently create a long equity position. This way, they can gain the equity market exposure they want, while only using a fraction of the capital. The remaining capital can be used for other investment opportunities.

Self-Directed Traders

Self-directed traders can use Equity Index futures to express a view on the overall equity market.

Rather than having to evaluate individual share values they can trade the entire index using the futures contract.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

Stock Index Education Home Page

Liquidity and Market Depth

Liquidity is perhaps one of the most important elements in gauging opportunities in a market. At its core, liquidity is the collective expression of traders’ opinions on the market.

Like any other market, these opinions are represented in a futures market either as existing positions held by traders, known in futures as open interest, or as buy or sell orders communicated to the rest of the market but yet to be executed.

The size and price of these orders may vary considerably, but the key element to consider is that the more opinions expressed in the market, the more liquid the market is.

Why is liquidity such an important element of market opportunity?

The reason is that the more participants there are, the more expressions of opinion on the market, the greater the likelihood that a single trader, like yourself, will encounter another with an opposing viewpoint that results in you both agreeing on a quantity and price to trade.

Another aspect to market liquidity is the ability to quickly check whether there is enough potential volume to suit their trading strategy. For example, an asset manager entering a new position with a large quantity of contracts would want to see a deep liquid market. A deep market allows them to execute a large order efficiently, while not causing significant price movements. The result is a more efficient execution, which reduces the trade impact costs of the transaction.

Summary

Understanding liquidity in a market is a critical consideration for traders before jumping into a trade. Futures markets offer deep liquid markets that let traders express their opinions in a tremendously efficient way.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure

Stock Index Education Home Page

Equity Index Notional Value and Price Fluctuation

Every Equity Index futures product has its own notional, or financial, value. For Equity Index Futures, the notional value is based on the futures index level and a fixed multiplier.

Calculating Notional Value

For Equity Index products, the notional value is defined as the product’s monetary equivalent at that price. This calculation may be expressed as follows:

Futures contract price x multiplier = Notional value

The math for calculating notional value is the same for all Equity Index futures, but the multiplier will change with each contract.

Below are a few examples;

The E-mini S&P 500® futures contract has a fixed multiplier of $50 per contract.

If the E-mini S&P 500® futures contract trades at 2175.00, then its notional value would be $108,750 per contract.

2175.00 x $50 = $108,750

The E-mini NASDAQ-100 futures contract uses a $20 multiplier.

If the E-mini NASDAQ-100 futures contract trades at 4625.00, then the notional value would be $92,500 per contract.

4625.00 x $20 = $92,500

Minimum Price Fluctuation (Tick)

Every Equity Index futures contract has a standardized minimum price fluctuation, also known as a “tick”. The tick value is the minimum price movement, either up or down, that can occur with each futures contract.

For example, E-mini S&P500® futures contracts have a minimum price fluctuation of a quarter of an index point or 0.25. Since a full point move in the E-mini S&P500® futures contract is worth $50, then a quarter point move would be worth $12.50.

Summary

Understanding the notional value of an Equity Index futures contract and the minimum price fluctuation gives traders the information they need to identify financial value for each contract and measure the cost for each tick movement in price.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

—————————————————————-

Privacy Notice

Disclosure