How To Profit From Program Trading

  • July 11, 2003
  • Chris Curran

On Thursday, the
September S&P 500 contract (SPU) opened with a 7-point gap to the
downside from Wednesday’s close, and never really looked up.  A big local made
several attempts to push the contract higher, and succeeded bidding it up to 996
twice before price backed off to 994.  Merrill Lynch, Goldman Sachs, and
Prudential-Bache were all big sellers, breaking the contract to a new low to
test its 20-day MA at 991.  Price formed a textbook “5-wave” descending triangle
on the 3-minute chart as the contract bounced off support a couple times before
breaking down (see chart).  S3 support was able to hold as the low of the
session as the contract was able to crawl back up on better afternoon volume
than we’ve seen lately, to close at a 50% retracement off the low. 


The September S&P contract finished -12.25 for
the session,  breaking its 20-day SMA and erasing most of this weeks’ gains. 
The contract has confirmed the top of a trading range and needs to close above
June’s high at 1,015 or below last week’s low at 960.50 to clear up its
near-term direction.  The only economic report on the schedule for Friday is the
Producer Price Index, which is expected to come in at a 0.3% increase, with the
core up 0.1%.

How I Use The Premium

The NYSE
defines a program trade as any portfolio trade consisting of 15 or more stocks
with a value of $1 million or more.  Program trading can take many shapes and
forms, however the best known type that we’ll concentrate on is “index
arbitrage,” in which traders look to profit from small, quick inefficiencies
between the equities and the futures markets.

An easy way
to explain this technique would be if you saw an ad in the newspaper for a car
selling for $10,000, and another ad in which someone was looking to buy the
identical car for $12,000.  Theoretically, you could buy the car from the first
person, turn around and sell it to the 2nd person, and pocket the
difference.  With index arbitrage, traders look to exploit the inefficiencies
that occur when the value of the stocks that make up the S&P 500 get out of line
with the S&P 500 futures.  When the spread, commonly referred to as the premium,
or PREM, between the 2 becomes too wide, program traders will buy stocks and
sell futures, creating a buy program.  And conversely, when the spread becomes
too narrow, program traders will sell stocks and buy futures, creating a sell
program, to bring the values back in line.

Does all
this really matter?  While it’s good to know the basics of program trading, the
fair value number we see on the news programs by itself is really irrelevant. 
The important part is to know when and where buy and sell programs may be
triggered, moving the market one way or the other.  This is accomplished by
watching the spread, or the premium (PREM), to see when it is hitting a buy or
sell program execution price.  I do this by plotting the S&P Premium on a simple
candle chart with the general buy/sell program levels marked with horizontal
lines (see chart).  Does this mean that you jump in long or short when the PREM
moves into buy or sell program range? Heck no!  This is best used for managing
an existing trade because although the futures may pop up a bit off of a buy
program, you need to remember that stocks are being bought, and futures are
being SOLD.  And vice versa for a sell program.


Daily Pivots
for 7-11-03

Symbol Pivot       R1 R2 R3 S1 S2 S3
COMP 1719.44 1731.38 1747.08 1759.02 1703.74 1691.80 1676.10
INDU 9062.44 9128.13 9220.21 9285.90 8970.36 8904.67 8812.59
NDX 1271.81 1282.86 1297.07 1308.12 1257.60 1246.55 1232.34
SPX 990.85 998.06 1007.46 1014.67 981.45 974.24 964.84
ESU 990.25 998.50 1008.25 1016.50 980.50 972.25 962.50
SPU 989.00 996.00 1003.30 1010.30 981.70 974.70 967.40
NDU 1274.50 1287.00 1301.50 1314.00 1260.00 1247.50 1233.00
NQU 1274.83 1287.67 1302.83 1315.67 1259.67 1246.83 1231.67
BKX 881.56 886.93 892.97 898.34 875.52 870.15 864.11
SOX 391.88 395.91 401.53 405.56 386.26 382.23 376.61
QQQ 31.71 32.09 32.58 32.96 31.22 30.84 30.35
SPY 99.32 100.02 100.73 101.43 98.61 97.91 97.20

Good luck with your trading on Friday!

Chris
Curran