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What makes an index like the S&P 500 tick
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What makes an index like the S&P 500 tick

  #11 (permalink)
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MXASJ View Post
Fat Tails gets the Daily Pint Award for the word arbitrageurs.



Four years of French, two years of German, two years of Latin and I still use arbs as a noun . Les Arbs is now definately out of my vocab...

This is really funny:

The Germans use the French word Arbitrageur (trading is immoral, better use a foreign word)
The French use the word arbitragiste (in France you are fined, if you use a foreign word)
Americans/English use anything that sounds similar: arb, arbitrager, arbitragist, arbitrageur, arbitrage dealer

I used a word that came to my mind naturally. I do not feel familiar enough to use English jargon, comme je n'utilise pas d'Argot pour m'exprimer en Français, car je n'ai jamais compris ce que veux dire "je m'enfou".

My apologies, if I offended anyone.

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The three would move up. If they didn't it would represent arb. Someone will step in to claim it.

But if someone step in to claim it, when does he claim it ? before the index is updated and exposed to all other participants ?

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trendisyourfriend View Post
But if someone step in to claim it, when does he claim it ? before the index is updated and exposed to all other participants ?

You do not need to update the index. What matters is the fair value of the futures contract. You can calculate it from the underlying by first applying the index formula, then adding interest at the risk-free rate, deducting expected dividends and convenience yield. A professional arb will know at any moment, whether he should go or wait. Arb trading can involve several intermarket spreads, depending on the model used.

There are even websites that will calculate you the exact differential that is required for arb action, so you can can take it into account, even if you cannot do arbitrage with a retail account.

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I must confess, i still don't get it. Fortunately, i don't need to understand it to trade but i would have liked to get a better grasp of that particular complex process. I'll keep asking questions about it but i would need to find the right persons to ask first. Have any reference to suggest ?

What i understand from our discussion so far is this... when the index is heavely traded in one direction but not the underlying stocks that compose it the difference would be absorbed by arbitrageurs. If this is the case, ie, someone somewhere absorb the excess value to stay in harmony with the underlying assets then it means technical analysis based on volume is a fallacy since anyway no matter the volume the excess will be absorbed to keep the index in synchronicity.

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trendisyourfriend View Post
I must confess, i still don't get it. Fortunately, i don't need to understand it to trade but i would have liked to get a better grasp of that particular complex process. I'll keep asking questions about it but i would need to find the right persons to ask first. Have any reference to suggest ?

What i understand from our discussion so far is this... when the index is heavely traded in one direction but not the underlying stocks that compose it the difference would be absorbed by arbitrageurs. If this is the case, ie, someone somewhere absorb the excess value to stay in harmony with the underlying assets then it means technical analysis based on volume is a fallacy since anyway no matter the volume the excess will be absorbed to keep the index in synchronicity.


Sorry, I did not get your question in the beginning. The index cannot be traded at all, so the arb would buy/sell futures contracts and sell/buy the underlying, if the differential exceeds the fair value differential of the futures contract. Maybe you can have look at this thread: It explains the correlation between the index and the futures contract on the index.

https://futures.io/traders-hideout/5509-s-p500-index-s-p500-index-futures-correlation.html

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trendisyourfriend View Post
.... Let's suppose we build our own model in order to understand the working of an index like the S&P 500.

If we have 3 companies: Cie A, Cie B and Cie C

Let's give them a value

Cie A: 100
Cie B: 75
Cie C: 50

Average is 75. Let's pretend 75 is the current value of the free-float capitalization-weighted index that represents these companies. If you or me speculate the index value will rise or decline and trade accordingly what is most likely to occur behind the scene to keep the index value coherent with the value of the companies that compose it. In the present case, if many big speculators and/or investors trade the index in one direction say up while no speculation is taking place directly on our three companies, what would happen ? Would it move up or stay in a synchronized state with our 3 companies ?


The 3 companies will move differently.
It's even possible that 1 or 2 are going down.

In reality the index is never in complete synchronicity with its underlyings.
That would mean that all swing parallel which can be seen easily by pulling up the appropriate charts is not the case.

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Here is a document that explains how the indices are built and maintained. the S&P 500 is based on market capitalization with a daily readjustment. Details in the booklet below.

The main point: Arb specialists know the formulae for the current day and the daily readjustment rules, so they will buy shares and sell the ES, if the futures is above its fair value by a minimum threshold which is required to cover trading costs and the risks associated with trading. If the future is below its fair value, they will purchase the future and sell the stocks.

To this type of arb, you need an inventory, ultra-low trading cost, sophisticated models to approximate the fair value and a server in colocation with the exchange to execute the two legs within milliseconds before somebody else does.

Arbitrage relies on the fact that the ES futures contract can be converted into the underlying at expiry. So any deviation from the fair value can only be temporary, and set aside trading costs and execution risk, arbitrage is a risk-free trade.

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