• Back when “the market” was just stocks,
some genius came up with a way to figure out
what all the stocks (at least the popular ones)
might be doing overall. Behold, the equity
index! Whether it’s price-weighted like the
Dow Jones Industrial Average, or capitaliza-tion-weighted like the S&P 500, an index is
just an average of stock prices. And when the
stock prices change, the index value changes.
HOW INDICES WORK
Indices turned out to be popular, and they
spawned all sorts of products like index
options and index futures. Those are handy
when you want to speculate on an index’s
direction. Fire up your thinkorswim® platform from TD;Ameritrade and have a look.
You might have /ES (the S&P 500 future) and
SPX (the index on the S&P 500) loaded up
on a watchlist. Because they’re both based
on the S&P 500 index, you figure when one
moves up, the other should, too, by the same
amount. But they don’t—at least, not always.
There are 500 individual stocks that make
up the SPX. Many of these stocks may trade
actively, with transactions occurring every
second. Others may trade less frequently—
every few seconds, or few minutes. Here’s
where it gets interesting. The SPX changes
when the last trade price of any component
stock changes. Meanwhile, the stock’s bid
and ask prices might be above or below the
last trade price, and more accurately reflect
its current value. But until that stock trades,
the SPX’s value doesn’t change. So, it doesn’t
necessarily reflect the current value of all 500
stocks. The SPX, then, is a snapshot of the
last trade prices.
The /ES future, on the other hand, is its
own product, and isn’t tied directly to the
S&P 500 stocks. That means the value of
/ES is determined by buyers and sellers of
the futures contract. If traders think the S&P
500 will rally, they’ll buy /ES and drive its
price up. The price of /ES doesn’t have to
wait until all 500 stocks trade. If /ES traders
think a stock that hasn’t traded yet has a
higher or lower price, they’ll adjust their
/ES trades accordingly. When traders look
for arbitrages between /ES and basket of 500
stocks, they look at the bid and ask prices of
the stocks, and not their last trade prices.
This is why SPX and /ES don’t always
move up and down together, tick by tick:
the SPX changes only when one of its stocks
trades, but /ES can change anytime. The
arb relationship means when one makes a
big move up or down, the other does, too.
But when there isn’t much movement in the
market, you may see /ES move up and down
more actively than SPX. You may also see
/ES move up or down quickly, and then a few
seconds or minutes later, SPX catches up.
And this is important if you’re trading SPX
options, because SPX options are priced o;
/ES prior to expiration.
WH Y PAY ATTEN TION TO /ES?
A trader who’s bullish on the S&P 500 might
consider selling a put on the SPX options. Say
you’re looking at a particular put, and notice
SPX hasn’t changed, but the put’s price has
dropped. Why? Possibly because the “
market” believes the S&P 500 might go up and
is pushing up the price of /ES. But all stocks
in the SPX haven’t traded yet. That SPX put
is looking at the /ES, not the SPX. And if you
want to know what the market’s doing, you
might consider looking at /ES, too. —Words by
Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and
opinions expressed in this article are solely those
of the author and may not be reflective of those
held by TD Ameritrade, Inc.
For more on the risks of trading and trading
options, see page 37, #1– 2.
The Hidden Risks
of Index Trading
PRO ; BIG IDEA: WHY DON’T SPX AND S&P 500 FUTURES
MOVE UP AND DOWN TOGETHER? THEY HAVE
THEIR DIFFERENCES, AND ONE MAY TELL YOU MORE
ABOUT WHAT THE MARKET MIGHT BE DOING.