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Fundamental question on index trading


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Fundamental question on index trading

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  #1 (permalink)
Toronto, ON
 
Platform: NT8
Trading: ES, NQ
 
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Hi All,

I've been trading ES, NQ, and most lately MNQ for the past few months with variable success (I'm net-losing right now, but optimistic). I keep exploring all the different forms of tutelage out there on price action analysis, and a lot of it seems to come down to a few repetitive tenets: read the price movements, guess where the buyers are waiting, sellers are taking over, losers are cutting losses, winners are profit-taking, etc etc. All seems to generally make sense.

Then it occurs to me:
- Index futures obviously follow their respective indices. They follow so closely, it's almost tick-for-tick (see attached chart for Aug5 on NQ vs Nasdaq100).
- The underlying indices are averaged prices of their constituent equities.
- The equities are traded in a fairly loosely correlated fashion. They are their own markets.
- The markets are mathematically jammed together into an index, which the futures follow.

All this would seem to suggest that price movement in index futures is not "free" to respond to the bullish/bearish tides within these products, unlike Metals, Ags, Energy, etc. All we equity index traders get to attempt is to "guess" the next move - not of the future, but of the index, and hope that we're pointed in the right direction while managing our risk as best we can.

In the Metals, Ags, Energies - no problem. The futures market is self-contained, doesn't follow anything underlying, and the buyers/sellers truly shape the pricing.

I know I'm probably too new to be making such iconoclastic suggestions about only the biggest futures market in the world, which is why I'm hoping this forum might clarify this for me:

- Does price action analysis 'really' work on index futures?
- If all ES does is follow S&P500, then there are no bulls or bears (except those that ensure tick-for-tick convergence with the index), then there must be very little to be gleaned from price action analysis, because pricing is not intrinsic in the futures market, right?

Or am I totally lost?

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  #2 (permalink)
SpeculatorSeth
Salt Lake City, Utah
 
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vlad1000 View Post
Hi All,
All we equity index traders get to attempt is to "guess" the next move - not of the future, but of the index, and hope that we're pointed in the right direction while managing our risk as best we can.

I've done quite a bit of looking at the way level 2 changes in the ES, and in general you will see more liquidity sitting in the direction that the index is moving towards. If price makes a significant change you'll see the orders flip around. However, I also found that the index can basically do whatever it wants regardless of how the scalpers in the ES are positioned. I believe that this supports your theory that most equity index traders are just trying to guess the direction.

Personally I think that most traders are misusing the index. The index exists so that you can see the overall market and not be affected by aberrations in individual issues. So shouldn't we be trying to trade the index off things that affect the entire market as a whole? Things like news and macro fundamentals? From this perspective the idea of trading the index off patterns or even analyzing orders seems a little dubious to me. The market arbitrages such edges away, and you just become part of the crowd of noise following each other's tails.

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  #3 (permalink)
Toronto, ON
 
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Thanks Seth. I've seen a lot of your YouTube streams and found them very helpful and interesting.

I know you trade Treasuries on Jigsaw, and I see how Treasuries would seem suitable for price action analysis, given that they are more of a "free" market than index futures (price movements are intrinsic). But you do also trade ES/MES. Do you apply the same order flow analysis to MES/ES as you do with ZB/ZN/ZF?

I wish there were micro-sized versions of Treasuries or Energies or Metals. Maybe someday CME will launch them. As it is, the leverage and margin requirements is a bit too heavy for a novice trying to only lose 'some' of his money.

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  #4 (permalink)
SpeculatorSeth
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I'm relying on news and fundamentals more and more. So when it comes to the DOM it's more about knowing where to get filled at. So I'm looking at what spot I can get in the queue, and how much actually trades when it touches. You want to trade in an area where there's interest, but also enough on the edge that you get less ticks against you. You can still look at this in ES, but it's not nearly as important as most prices get cleared anyways.

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  #5 (permalink)
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vlad1000 View Post
Hi All,

- If all ES does is follow S&P500, then there are no bulls or bears (except those that ensure tick-for-tick convergence with the index), then there must be very little to be gleaned from price action analysis, because pricing is not intrinsic in the futures market, right?

You mention a number of questions about price action trading, most of which I will pass on, because I don't want to comment on a particular trading method.

But I will touch on one of the points you raised, namely, does buying and selling in the ES futures market actually move price in that (futures) market? When put this way, it may seem odd, but the question is reasonable, because it raises the question of the relationship between the futures market and the underlying index.

The price of the ES is in fact determined by buying and selling in the market it is traded in, as is the price of anything in a competitive market. On the other hand, the value of the S&P index is not itself set in a market, but is calculated based on the values of 500 individual stocks, which are also traded competitively in their market. The index is just a non-traded computation. How then are the index, the stocks and the futures connected? Good question.

The basic purpose of the futures market is to enable hedging by holders or buyers of the underlying index/commodity/whatever to shield themselves from risk of loss (including metals, energy, agricultural, bonds, indices, and anything else).

The S&P index reasonably represents a large basket of stocks, such as are held by many large stock funds. These holders have an interest in hedging their holdings in the futures market, where they may take positions to offset potential negative changes to their holdings. A long position in a large number of stocks is protected by a short position in the index futures; one goes up (the futures short) when the other (the stock holdings) goes down. There are also much more involved strategies that clever people have evolved.

The futures market lets the holders who are not willing to accept market risk (hedgers) to hand off the risk to others who are (the unhedged traders, such as you and me.) Fully hedged traders have no profit or loss from market movements, which is what they are looking for; unhedged traders do, which is what we are looking for.

What makes this work is that, when the price of the baskets of stocks (or barrels of oil or whatever) in their markets diverge from the price of the futures contract, arbitrage will bring them closely back in line (a price difference between the stocks in the S&P index and the ES is a profit opportunity -- so arbs buy a basket of stocks and sell the futures, or vice-versa, which brings the prices back in close agreement.) Arbitrage keeps the composite prices of all the different index stocks (as represented by the index) closely connected to the price of the futures index.

There is an active market in physical oil, for example, separate from the market in oil futures. Yet, by absolutely no coincidence, there is a close connection between the futures price and the current "spot" price (price for physical oil right now), adjusting for factors such as the cost of money to the settlement date.)

So, when the price of the underlying item moves in its market, does the futures contract also move? Yes. When the price of the futures contract moves in its market, does the "spot" price also move? Yes. Why? Because the fundamental needs of hedgers requires the markets to stay in step, and this leads the arbitrageurs to act to keep them that way. So do buyers ("bulls") on the futures side move the market? Yes. How about bulls on the side of stocks? If you mean, the sum of bulls in a large number of index stocks? Yes. The same for bears, pushing prices down, on either side or both sides. Which one, the stocks or the futures, is determinative? Take your pick.

Without this connection, there would be no workable futures market, because it would be useless for hedging.

Quoting 
In the Metals, Ags, Energies - no problem. The futures market is self-contained, doesn't follow anything underlying, and the buyers/sellers truly shape the pricing.

Actually, they are all the same.

They are tightly connected to the underlying, to the spot cash price for the physical commodity, as they must be. Otherwise, there would be no reality, and no point, to the prices in the futures markets. But at settlement, oil, or metals, or wheat, or soybeans, or whatever, will actually change hands according to the contract, for the settlement price, and this has to be the same price as the spot cash price for the underlying at that time, or there would be no transaction, and nothing real will have been going on in the futures market. But there is.

Did this address this particular question you had? I hope it shed some light, anyway.

Sorry to go on so long about this. One of my many failings.

Bob.

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  #6 (permalink)
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bobwest View Post
There is an active market in physical oil, for example, separate from the market in oil futures. Yet, by absolutely no coincidence, there is a close connection between the futures price and the current "spot" price (price for physical oil right now), adjusting for factors such as the cost of money to the settlement date.)

Regarding this point from my last post, I had to dig into memory (and the Search function) to come up with a practical example of the relationship between a current futures price and its underlying spot price, showing the role of the cost of money in the futures price compared to the spot price.

This example addresses a price difference that was noted at the time (Jan 4, 2020) between the spot price of the Euro in US Dollars and the March 2020 Euro Futures contract (the E6H0 contract), also in US Dollars:


mzelixon View Post
Anyways, I've noticed something.

The price between the spot EUR/USD is not equal to the FX Eurodollar!

Atm spot price is ~1.1040, and the futures price is 1.1072 !!!

That's a 30 tick difference!

Can someone explain to me why the Futures Price here is not DIRECTLY correlated to the spot price?

@SMCJB did the math:


SMCJB View Post
Spot FX represents the currency rate for immediate delivery (2 days?) while E6H0 has a last trading day of 16th March and delivery is 18th March.

The difference in the two prices is due to the effect of interest rates for those 50 days. ECB rate is currently -0.5% and US Fed Funds is 1.55%. Lets assume you do a spot transaction today at so you have $1.104 but owe 1.000. In 50 days time your $1.104 will have grown to $1.10625 (1.104 * 1.015^(50/365)) while you will now only owe 0.99931 (1 * 0.995^(50/365)) meaning the rate in 50 days time is 1.10625/0.99932 = $1.107. Viola!

A quick practical example of the tight connection between spot and futures prices, taking into account the current cost of money between now and settlement date. When adjusted, the prices are going to be very closely related, and this will apply to all futures and spot markets.

Link:

Bob.

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Legendary Market Wizard
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A lot of the previous discussion on ES assumes that the underlying markets are bigger than the futures markets and hence futures follows the index. I don't think that's always the case. In the early morning when ES futures are trading but stocks aren't, do the stocks take their lead from the futures? Another example the CL future contract is much bigger than the Spot WTI Market. Now the futures market does move because of perceived fundamentals in the spot market, and at some point they do converge, but you never hear, CL was up today because there was a big cash buyer in the spot market. The spot market isn't big enough. Crude's an interesting example because not all crude is the same, while a share of Microsoft is the same as any other share.

bobwest View Post
A quick practical example of the tight connection between spot and futures prices, taking into account the current cost of money between now and settlement date. When adjusted, the prices are going to be very closely related, and this will apply to all futures and spot markets.

There are some markets where forward pricing has a hard arbitrage rule that will stop them ever getting out of line. The currency example quoted is a good example. Forward Equity Index Prices are another (Dividend Yield minus Cost of Carry). Then there are markets that have a theoretical forward bound dictated by storage. Hence Forward Months are capped at Spot Months plus Storage plus Cost of Money plus Insurance. Unfortunately that assumes there is limitless storage, which isn't the case, and when Storage runs out prices can do anything, as we saw with Crude a few months back. Then there are markets where there is no storage capability at all and prices are unbounded. Electricity is one that comes to mind, not sure if there are any perishable markets that behave similarly.

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SMCJB View Post
A lot of the previous discussion on ES assumes that the underlying markets are bigger than the futures markets and hence futures follows the index. I don't think that's always the case. In the early morning when ES futures are trading but stocks aren't, do the stocks take their lead from the futures? Another example the CL future contract is much bigger than the Spot WTI Market. Now the futures market does move because of perceived fundamentals in the spot market, and at some point they do converge, but you never hear, CL was up today because there was a big cash buyer in the spot market. The spot market isn't big enough. Crude's an interesting example because not all crude is the same, while a share of Microsoft is the same as any other share.

There are nuances, and, as @SMCJB points out, not every market is actually the same. So I did some simplification here. Also, there is a significant amount of pre-NYSE trading in ES and the other equity markets, and this just goes on without any reference (directly at least) to the S&P index itself, because the individual stocks are not trading during those times. So to a degree, the equity futures and the actual equity (stock) markets are uncoupled for a large part of the day, before and after stock trading hours. However, if there has been a large overnight run up or down in ES, when trading in the NYSE begins at 9:30 AM ET, prices start pretty close to the overnight ES levels. Which is another way they are related, this time with the ES trading freely and the cash stock market trailing along after.

It's not that any one market is always dominant, futures or spot, but that the original question essentially was based on an idea that the cash stock market, represented by the S&P index, was where the transactions that move the markets take place, and that thinking about the buying and selling pressure in the ES itself is immaterial:

vlad1000 View Post
All this would seem to suggest that price movement in index futures is not "free" to respond to the bullish/bearish tides within these products, unlike Metals, Ags, Energy, etc.
...
- If all ES does is follow S&P500, then there are no bulls or bears (except those that ensure tick-for-tick convergence with the index), then there must be very little to be gleaned from price action analysis, because pricing is not intrinsic in the futures market, right?

My point, somewhat belabored, was that this is not the case. I should have said, during the NYSE hours when the stock market is trading at all, the actions in both the futures and the stock markets are kept in step by arbitrage and neither is the "primary" one. So does buying and selling pressure in the ES move the ES? Yes. Does buying and selling in the 500 stocks move them? Yes. Do the two markets stay pretty close together anyway? Yes. Then, after hours, the futures are their own show until the next morning, and they connect up with the cash stock markets for a while again.

And finally, to my point about arbitrage keeping markets in line -- well, maybe it doesn't always, at least not in a simple way:


SMCJB View Post
There are some markets where forward pricing has a hard arbitrage rule that will stop them ever getting out of line. The currency example quoted is a good example. Forward Equity Index Prices are another (Dividend Yield minus Cost of Carry). Then there are markets that have a theoretical forward bound dictated by storage. Hence Forward Months are capped at Spot Months plus Storage plus Cost of Money plus Insurance. Unfortunately that assumes there is limitless storage, which isn't the case, and when Storage runs out prices can do anything, as we saw with Crude a few months back. Then there are markets where there is no storage capability at all and prices are unbounded. Electricity is one that comes to mind, not sure if there are any perishable markets that behave similarly.

Which shows that there is always more to a situation than you would first think. (Or that I did, anyway.) Thanks for the additional perspective and info.

Bob.

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