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How To Use S&P 500 Futures To Predict Market Movement


Every day, the S&P 500 index opens for trading at 9:30 AM EST and closes at 4:00 PM EST.
S&P 500 futures contracts, on the other hand, trade 24 hours a day in different markets all over
the world.
If the S&P 500 closes the trading day at 2,000 and the S&P 500 futures are trading at 2,020 the
next morning, that creates a spread of 20 points. That does not mean the S&P 500 should open
20 points higher.

Theoretically, owning every stock in the S&P 500 should produce the same return as buying
S&P 500 futures contracts and holding until expiration. However, there are two practical
differences between the two scenarios.

First, it would be extremely expensive to buy shares of every single S&P 500 stock. One share of
Autozone Inc. ($508.32), one share of Chipotle Mexican Grill Inc. ($660.61), one share of
Google Inc. ($560.88), one share of Netflix Inc. ($461.62) and one share of Priceline Group
Inc. ($1,102.19) would run up a tab of $3,293.62. After those five stocks, there are only 495
more to buy.
Practically, to buy the entire S&P 500, it would likely be necessary to borrow money and pay
interest on the borrowed funds. In addition, many of the components of the S&P 500 pay
dividends, and S&P futures contracts do not.

Calculating Fair Value

These two differences between the S&P 500 and S&P 500 futures mean that an adjustment must
be made to the value of the S&P 500 index price before making a fair, apples-to-apples
comparison to the S&P 500 futures. This "adjustment" is called "fair value," and here is the
typical formula for calculating it:
FV = S * [1 + (I - D)]


FV = fair value
S = the current price of the S&P 500 index
I = the current interest rate to borrow funds to buy the S&P 500 components
D = the current dividend payment rate of the S&P 500 components

When watching Squawk Box before the market opens, the scroll at the top of the screen shows
the change in the S&P 500 futures and the "fair value" CNBC has calculated.
Imagine the S&P 500 closes on Wednesday at 2,000 exactly, and at the time the market closes
the S&P 500 futures are priced at 2,020. Next, imagine that overnight, the S&P futures drop in
price by 10 points to 2010. On Thursday morning, CNBC calculates the "fair value" for the S&P
500 futures to be 2,024. The scroll on CNBC's screen will read "S&P500 Fut -10 FV +4"

The -10 comes from the 10-point drop in the price of the futures since the previous day's close,
and the +4 comes from the difference between the calculated fair value of the futures (2,024) and
the 2,020 price at the previous day's close.

Predicting The Open

The real meat on the bone of this discussion of fair value is that these two numbers can easily be
used to determine what CNBC calls the "implied open." If you take the change in the S&P 500
futures (-10) and subtract the fair value (+4), you get an approximation of the change that will
likely occur in the actual S&P 500 index immediately after the opening bell.

In this hypothetical scenario, (-10) - (+4) = -14, or a 14-point implied opening drop in the S&P

Using Index Futures To Predict The Future

An index futures contract binds the parties to an agreed value for the underlying index at a
specified future date. For example, the September futures contract for the current year on the
Standard & Poor’s 500 Index reflects the expected value of that index at the close of business on
the third Friday in September. Like any derivative, it’s a zero-sum game: One party is long and
the other short - and the loser must pay the winner the difference between the agreed index
futures price and the index closing value at expiration.

Fair Value of an Index Future

Although index futures are closely correlated to the underlying index, they are not identical. An
investor in index futures does not receive (if long) or owe (if short) dividends on the stocks in the
index, unlike an investor who buys or sells short the component stocks or an exchange-traded
fund that tracks the index.

Index futures trade on margin, too: An investor who buys $100,000 worth of futures must put up
around 5% of the principal amount ($5,000) at the outset, whereas an investor in the stock
components or an ETF must put up the full $100,000.

The index futures price must equal the underlying index value only at expiration. At any other
time, the futures contract has a fair value relative to the index, which reflects the expected
dividends forgone (a deduction from the index value) and the financing cost for the difference
between the initial margin and the principal amount of the contract (an addition) between the
trade date and expiration. When interest rates are low, the dividend adjustment outweighs the
financing cost, so fair value for index futures is typically lower than the index value.

Index Futures Arbitrage

Just because index futures have a fair value doesn’t mean they trade at that price. Market
participants use index futures for many different purposes, including hedging; adjusting asset
allocation through index futures overlay programs or transition management; or outright
speculation on market direction. Index futures are more liquid than the market in the index's
individual components, so investors in a hurry to alter their equity exposure trade index futures -
even if the price isn’t equal to fair value.

Whenever the index futures price moves away from fair value, it creates a trading opportunity
called index arbitrage. The major banks and securities houses maintain computer models that
track the ex-dividend calendar for the index components, and factor in the firms’ borrowing costs
to compute fair value for the index in real time. As soon as the index futures price premium, or
discount to fair value, covers their transaction costs (clearing, settlement, commissions and
expected market impact) plus a small profit margin, the computers jump in, either selling index
futures and buying the underlying stocks if futures trade at a premium, or the reverse if futures
trade at a discount.

Index Futures Trading Hours

Index arbitrage keeps the index futures price close to fair value, but only when both index futures
and the underlying stocks are trading at the same time. While the stock market opens at 9:30am
and closes at 4pm, index futures trade 24/7 on platforms like Globex, an electronic trading
system run by CME Group. Liquidity in index futures drops outside stock exchange trading
hours because the index arbitrage players can no longer ply their trade. If the futures price gets
out of whack, they cannot hedge an index futures purchase or sale through an offsetting sale or
purchase of the underlying stocks. But other market participants are still active.

Index Futures Predict the Opening Direction

Suppose good news comes out abroad overnight - the ECB cuts interest rates, or China reports
stronger than expected growth in GDP. The local equity markets will probably rise, and investors
may anticipate a stronger U.S. market, too. If they buy index futures, the price will go up. And
with index arbitrageurs on the sidelines until the U.S. stock market opens, nobody will
counteract the buying pressure even if the futures price exceeds fair value. As soon as New York
opens, though, the index arbitrageurs will execute whatever trades are needed to bring the index
futures price back in line - in this example, by buying the component stocks and selling index

Investors cannot just check whether the futures price is above or below its closing value on the
previous day, though. The dividend adjustments to index futures fair value change overnight
(they are constant during each day), and the indicated market direction depends on the price of
index futures relative to fair value regardless of the preceding close. Ex-dividend dates are not
evenly spread over the calendar, either; they tend to cluster around certain dates. On a day when
several big index constituents go ex-dividend, index futures may trade above the prior close but
still imply a lower opening.

… In the Short-Term
Index futures prices are often an excellent indicator of opening market direction, but the signal
works for only a brief period. Trading is typically volatile at the opening, which accounts for a
disproportionate amount of total trading volume. If an institutional investor weighs in with a
large buy or sell program in multiple stocks, the market impact can overwhelm whatever price
movement the index futures indicate. Institutional traders do watch futures prices, of course, but
the bigger the orders they have to execute, the less important the index futures direction signal

Late openings can also disrupt index arbitrage activity. Although the market opens at 9:30am,
not every stock starts to trade at once. The opening price is set through an auction procedure, and
if the bids and offers do not overlap, the stock remains closed until matching orders come in.
Index arbitrage players won’t step in until they can execute both sides of their trades, which
means the largest - and preferably all - stocks in an index must have opened. The longer index
arbitrageurs stay on the sidelines, the greater the chances that other market activity will negate
the index futures direction signal.

The Bottom Line

If the futures price suggests the market will rise on the opening, investors who wish to sell that
day may want to wait until after the market opens before entering their order, or set a higher
price limit. Buyers may want to hold off when index futures predict a lower opening, too.
Nothing is guaranteed, however; index futures do predict the opening market direction most of
the time, but even the best soothsayers are not always right.

Investors can monitor futures prices and fair values on websites like CNBC or CNN Money, both
of which also show pre-market indications for individual stocks (a less reliable indicator due to
poor liquidity).

Why are SPX and /ES Different Prices

If you see the difference between the SPX and the /ES and you think there is money to be
made in the difference you really need to watch this segment which will explain why the
difference exists and how the market won't give you such an easy arbitrageable
opportunity, focusing on dividends and the cost of carry. Every trader can benefit from the
information here.

SPX is the S&P 500 Index. The index cannot be traded directly but options based on the SPX
trade an average of more than 800,000 contracts per day. /ES represents the E-mini S&P
500 futures contract.

A graph of the price of the SPX (S&P 500) versus the price of the /ES (E-mini S&P 500
futures) from December 16th to December 22 was displayed. Both of these trading vehicles
are representative of the S&P 500 but the prices can be very different. Some may think that
this difference can be arbitraged and if you are in that group we are here to burst your

A table of the SPX price, the March /ES price and the cost basis of March SPX Synthetics was
displayed. Tom and Tony explained how the SPX options are not priced to SPX but to the
future value of the index adjusted for dividends and interest (which is how /ES futures are
priced). There is no profit potential by trading SPX options against /ES.

The options on SPX are European exercise (meaning exercisable only at expiration), so you
cannot capture profits on deep ITM options that are trading for less than intrinsic by
exercising prior to expiration. Another table of the SPX price, the Feb 1700 Call Price, and
the Intrinsic Value of the Call was displayed.

The guys go into greater detail to explain why the futures are currently trading at a
discount to SPX. This previously unforeseen situation is the result of the current extremely
low interest rates and Tom and Tony elaborate on that and present a simple formula.
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the takeaways
and other insights on why the difference in price exists between the SPX and the /ES and
the math behind the pricing of the cost of carry.