Q&A
Since You Asked
| Confused about some aspect of
trading? Professional trader Don Bright of Bright Trading
(www.stocktrading.com), an equity trading corporation, answers a
few of your questions. |
Don Bright of Bright Trading |
UNDERSTANDING SPOOS PREMIUM
I have been researching the PREM ("premium") or spread between the
SPOOS and the S&P cash index. I am trying to understand it better to
help in speculating day-to-day market direction. Can you shed some
insight into this? --Argula
Good question about a very valuable tool that is necessary for every
trader's toolbox. First off, the Standard & Poor's 500 spot price,
generally reflected with a symbol of SPX, is the actual index price for
all 500 stocks (just like the Dow Jones Industrial Average is for the
Dow 30 stocks). The SPOOS, as we call them, are the S&P 500 futures
contract, interchangeable with the emini contract (smaller contract
based on same 500 stocks).
Now, let's assume you were going to buy all 500 stocks for cash. You
would be losing the interest money you would have received, or if you
had to borrow money to buy all those stocks, you would have to pay
interest on that money. Either way, we call this amount the "cost of
carry." This is the cost to hold those stocks. In lieu of buying all the
stocks, you could simply buy the futures contract for much less money,
due to the leverage involved. So if you were to buy the futures contract
instead of the stocks, you would be willing to pay a premium over the
current spot price to compensate for the interest you are not paying.
This is called the "fair value" (FV) for the futures. For example, if
the spot price is 1283 and the cost of carry is 2.00 (for the time
period until the next quarterly expiration of the futures contract),
then the futures should trade at 1285 (all other market factors being
equal). If the futures are actually trading at 1289, then the premium to
fair value would be four S&P points, indicating a higher opening of
the overall market (we are assuming the premarket opening time frame).
For comparison, the Dow industrials would likely open up approximately
30-35 points.
Let's take this one step further. During the trading day, the futures
will trade around fair value, but venture into either premium or
discount territory. This is the amount above or below the valuation
where they should trade if the market were flat. This premium or
discount to fair value means that the floor traders and program traders
(and other arbitrageurs) will sell the futures above fair value (and
perhaps buy a basket of stocks to hedge themselves, or even buy all 500
stocks at times), and buy futures below fair value and reverse their
stock positions. This allows for locking in a profit (theoretically).
So the premium (or discount) shows the short-term movement of the
intraday market. The symbol PREM (on most datafeeds) is the difference
between the future and the spot price, but you must consider the fair
value cost of carry to give yourself a valuable number.
You may want to consider going to www.programtrading.com for a
detailed formula.
Hope this helps!
ABOUT STOP-LOSS ORDERS: A MESSAGE-BOARD CONVERSATION
I have read/heard that sometimes the retail trader's stop-loss and
target orders can be seen by other traders (though not at-home traders).
Is this true? As a result, your positions can be stopped out by market
makers, I assume. Is this a situation only from the "old days," or is it
present day also? If so, is it isolated to a few markets or most in
general? I'd think electronic markets are somewhat invisible. Just
curious--Trader Guy 02
I sit with 100 other professional traders, and each and every one
also speaks of a "they" out there who is responsible for the losses,
stops, and so on -- "they" this, "they" that, all day
long.--Rhymeswithorang
I have to agree with you both. For 30 years, "we" have been "they" --
and we don't see anything! Many stops are held by the retail broker, so
they "see" them. For insight into how market makers may use what they
"see," check this out for some insight:
www.stocktrading.com/wsjknight1.shtml
Since the retail trader only accounts for single-digit percentage
volume on the exchanges, I wouldn't worry too much about market makers
or specialists. On the other hand, we teach our people to only use
alerts and never place stop orders (for several reasons).
Could you please elaborate on these reasons? -- Math_Wiz
The primary reason I don't use actual stop orders is that I want to
"see" what the market is doing when the alert goes off. Was it a bad
print, was it a negotiated trade that generally bounces back, was it a
trade-through (when a stock prints at a price that is outside the quoted
bid/offer prices)? Is it news related, sector related, disaster
related-is there another stock that I should buy or sell to hedge vs.
cover a losing trade? This is all part of tape reading. Stop orders are
generally best used only by investors who cannot sit and watch the
market all day. Hope this helps.
E-mail your questions for Bright to Editor@Traders.com, with the
subject line direct to "Don Bright Question."
Originally published in the May 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
All rights reserved. ©
Copyright 2006, Technical Analysis, Inc.
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