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Contract price not matching underlying index price.


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Contract price not matching underlying index price.

  #1 (permalink)
Bukwang
San Francisco CA/USA
 
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I've been trading index futures and would like some help or pointers around how the contract pricing is calculated. For example, most days, the contract price is tracking the underlying index price quite closely. I am tracking the index price to determine when to enter or exit my trades. I usually get a good correlation between the index and the contract, with a fairly consistent difference that I can account for. However, some days, like today, the index is moving nicely, so I put in a trade order and the contract price is wildly different. 30-40 minutes later the contract price is back inline with the index. But, for my next trade it is off again. It was different by about 40 points today on the ASX. My understanding is that the contract price is based on the underlying price, the interest rate, dividend yield and the time to expiration. I assume interest rate and dividend are constant within a trade lasting a few hours. Yet, it seems to be factoring in liquidity or speed of movement or something else. I'm not expecting the prices to be perfectly matched. But I my experience so far shows they are typically at a fairly consistent distance apart. Anyone experiencing this? Anyone have any explanations? Apologies if this is a well know phenomenon, it caught me out today. Thanks!

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  #3 (permalink)
 
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 Fat Tails 
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Index and futures contract can be temporarily out of whack.

Once the differential becomes important, arbitrageurs should take care of the problem.

Could you please post the charts in order to allow us to assess your observation?

I have not subscribed to ASX data.

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  #4 (permalink)
Bukwang
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OK - I tried to attach links and images of the plots, but I need to have posted 5 times...

If it helps, here are the trades I actually made:

Thursday:
I TYPE I-ENP I-EXP C-ENP C-EXP I_CAP C_CAP D_CAP
1 SHORT 5573.08 5562.78 5564.00 5562.00 10.3 2 -8.3
2 SHORT 5550.75 5526.88 5544.00 5525.00 23.87 19 -4.87
3 SHORT 5515.95 5524.69 5509.00 5522.00 -8.74 -13 -4.26
4 SHORT 5515.08 5512.02 5509.00 5509.00 3.06 0 -3.06
I_CAP_TOT = 28.49
C_CAP_TOT = 8


Friday:
I TYPE I-ENP I-EXP C-ENP C-EXP I_CAP C_CAP D_CAP
1 LONG 5548.43 5600.21 5575.00 5602.00 52.78 27 -25.78
2 LONG 5608.58 5599.94 5613.00 5596.00 -8.64 -17 -8.36
3 SHORT 5587.39 5598.35 5585.00 5605.00 -10.96 -20 -9.04
4 LONG 5603.43 5593.52 5610.00 5592.00 -9.91 -18 -8.08
5 SHORT 5591.07 5598.33 5589.00 5605.00 -7.26 -16 -8.74
I_CAP_TOT = 16
C_CAP_TOT = -44

These show the entry and exit price for the Index and the Contract. Then the price movements captured by the index and the contract and finally the difference in the price capture.

I use the index price to determine whether to enter or exit the trade. The contract price only has a resolution to the nearest $, so I expect some rounding losses there. Plus there is the spread which usually accounts for another couple of $. So, in general I expect to see about 3 or 4 $ of difference in movement per trade. This has been quite consistent.

However, there are two issues. 1) I usually get hit with a really big difference in pricing for the trade I take as soon as the market opens. 2) On Friday, all my trades were hit with large differences, so I ended up making a loss when my thought it should have captured a small profit.

I have built into my system to expect losses of $4 a trade. Friday's average loss per trade was far bigger and I don't understand what was causing this. Was it just a bigger spread?

Bukwang

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  #5 (permalink)
 choke35 
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Bukwang View Post
... For example, most days, the contract price is tracking the underlying index price quite closely. ... My understanding is that the contract price is based on the underlying price, the interest rate, dividend yield and the time to expiration. ... Yet, it seems to be factoring in liquidity or speed of movement or something else.

Like many beginners, you have some awry basic assumptions about the relation between futures and the underlying.

Index futures are assets of their own - often the most liquid assets you can get in and "for" a market.
As opposed to this, you cannot even directly trade the underlying index.

So how do you expect portfolio adjustments to work?
By a calculational underlying that cannot even be traded?

Normal is:
- the index future triggers a move
- arbitrage starts ( @Fat Tails mentioned that), ie: portfolios/baskets of assets are bought and sold to eliminate free lunches
- the index value is recalculated, ie: the index value delta tracks the future's move
- the spread between future price and index value normalizes (this "normal" is the only point where interest rate, dividend yield and the time to expiration count, but not for the move)

So most of the time, the prognostical value - and that is what you are erroneously assuming - of the calculational index value for the future is close to zero as it confuses trigger and effect.
("Most of the time" means that there is one major exception, namely disruptive events in single stocks or groups of stocks in the index; there, portfolio/basket programs often lead.)

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  #6 (permalink)
 choke35 
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One more remark about the pics that you have posted.

The contract that you picked has virtually no trades.
Most of the time, old prices are shown, ie. the charted last price is "worthless".
You could only trade vs bid/ask (bid/ask not shown in your charts) - if at all.

Effects:
- For the market: Such illiquid markets need many more rounds of arbitrage than e.g. the ES.
- For the trader: You experience wider spreads, slower adjustments and higher slippage.

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  #7 (permalink)
 
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 Fat Tails 
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choke35 View Post
One more remark about the pics that you have posted.

The contract that you picked has virtually no trades.
Most of the time, old prices are shown, ie. the charted last price is "worthless".
You could only trade vs bid/ask (bid/ask not shown in your charts) - if at all.

Effects:
- For the market: Such illiquid markets need many more rounds of arbitrage than e.g. the ES.
- For the trader: You experience wider spreads, slower adjustments and higher slippage.

I think that the contract month July 2015 is illiquid for index futures. Maybe the June or September contract is the correct contract to look at.

I must admit that I do not know roll dates for the ASX futures, as I do not trade Australian futures.

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  #8 (permalink)
 choke35 
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Fat Tails View Post
I think that the contract month July 2015 is illiquid for index futures. Maybe the June or September contract is the correct contract to look at.

I must admit that I do not know roll dates for the ASX futures, as I do not trade Australian futures.

You are right. The front months are illiquid, but nevertheless quoted by the ASX:



Only September seems to be more or less liquid - but still rather underwhelming ...

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  #9 (permalink)
 
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 bobwest 
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Bukwang View Post
I've been trading index futures and would like some help or pointers around how the contract pricing is calculated. For example, most days, the contract price is tracking the underlying index price quite closely. I am tracking the index price to determine when to enter or exit my trades. I usually get a good correlation between the index and the contract, with a fairly consistent difference that I can account for. However, some days, like today, the index is moving nicely, so I put in a trade order and the contract price is wildly different. 30-40 minutes later the contract price is back inline with the index. But, for my next trade it is off again. It was different by about 40 points today on the ASX. My understanding is that the contract price is based on the underlying price, the interest rate, dividend yield and the time to expiration. I assume interest rate and dividend are constant within a trade lasting a few hours. Yet, it seems to be factoring in liquidity or speed of movement or something else. I'm not expecting the prices to be perfectly matched. But I my experience so far shows they are typically at a fairly consistent distance apart. Anyone experiencing this? Anyone have any explanations? Apologies if this is a well know phenomenon, it caught me out today. Thanks!

Hi, I notice that you have not yet indicated that your question has been answered to your satisfaction (although the replies to date were all good, in my opinion.) Let me see if I can add something.

The futures price is not actually ever "calculated" based on the index price, or based on anything else, either. It is set by traders who are buying and selling it directly in the futures market. Some of them may, or may not, have a calculation that they use to find the "right" value based on the index, and it may be that at any one time the futures price does hit that calculation.... But there are a lot of reasons why traders would buy or sell at any time, and the outcome of their collective decisions at any moment will determine the futures price at that moment.

@Fat Tails has mentioned that if the index and the futures contract begin to diverge too much, arbitrage will take place to bring them back. The arbitrageurs will buy stocks and sell the futures (if the futures are high) or vice-versa (if the futures are low) to benefit from the spread between them (buy low, sell high.) This will force the spread to contract and the prices to come back into line. Also, traders may simply observe an unusual spread and buy or sell in the expectation that it will narrow, which will also force it do just that.

But there is nothing that says that intrinsically there must be some fixed relationship between the two prices. It's supply and demand in both cases, in different markets, and they will fluctuate in and out of sync all the time. They may tend to a certain relationship over time, but you will never be able to rely on that relationship holding at the particular time you are trading.

Given this, it does not really make sense to use the index price to make any trading decision in the futures market. It would seem better to simply use the futures market itself, which is basically what everyone else who is trading the futures is doing. That's where you will get your trade executed, after all.

Both @Fat Tails and @choke35 have also called attention to the liquidity issue. If there is basically little or no trading in your contract, there will be even less correlation with the index price, and you will get seriously hurt in your trade fills (buys will be filled high, sales will be filled low).

Essentially, if you're not doing some sort of arbitrage yourself, there is no reason to rely on the index price at all, and if you do not have enough liquidity in your chosen futures contract, you should find one that does. The lines of dashes in the futures chart you posted means that no one was trading at all at those times -- that kind of market simply cannot be traded with any expectation of success. You will have no way to know what your likely buy or sell price will be (and the index will not tell you, either.) Take a look at a liquid index future like the US S&P contract (ES), for example, and you will see the difference. You will never see any dashes, for the current contract month. (The current ES contract month is September.)

There may, of course, be reasons to be aware of the overall trends of the index itself in order to understand the context of futures price movement, but not in place of the futures price itself when you get down to placing trades.

I hope some of this helps make the issues more clear.

Bob.

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  #10 (permalink)
Bukwang
San Francisco CA/USA
 
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Thanks everyone! Apologies for late response, I've been offline for a few days.

This has given me a much better understanding of how things are linked, or in this case, not linked together.

I will continue my hunt for futures contracts that provide the price movement AND the trading volumes that I am looking for. The ASX September contract certainly looks better, but I'm sure there are others out there that have an even better fit. I appreciate your patience.

Cheers!

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Last Updated on July 3, 2015


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