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What are Fair Value, Sell Active, Sell Threshold, Buy Threshold, and Buy Active?
When do sell programs and buy programs occur? |
Index arbitrage is a form of program trading
activity that can produce sudden and possibly sharp market movements.
Foreknowledge of the likelihood of an impending program trade can
help investors with the timing of initiating either long or short positions in stocks, index futures,
Exchange Traded Funds (ETFs), and options. Specifically, investors could benefit from knowing the
conditions under which program trades might occur by either avoiding trades in the opposite direction
or taking trades in the same direction. For example, if conditions indicate that a sell program is
imminent, an investor might wish to defer a stock or call option purchase until the futures and
equities markets have returned to equilibrium and the sell program conditions no longer exist. Conversely,
if buy program conditions exist, an investor could proceed to execute a stock or call option purchase
and possibly benefit from a rising market caused by the buy program.
There are two types of index arbitrage programs: sell and buy.
Buy programs occur when the futures market is over-valued relative to the stock market
and consists of the index futures being sold and the stocks in the index being bought.
Sell programs, the opposite case, occur when the futures market is under-valued relative
to the stock market and consists of the index futures being bought and the stocks in the
index being sold. Over-valued and under-valued conditions arise because trading in the futures
and equities markets occurs independently.
Index arbitrage program trades are triggered when the arithmetic difference between an index's
futures contract price and the index's spot (or current) price reaches an over or under-valued extreme.
This arithmetic difference is known by the various names of premium, basis or spread; this website uses
the term premium because it is used by CNBC and many quote services. An example of the calculation of
premium follows: if the S&P 500 futures contract
price is 1409 and the S&P 500 spot index is 1400, the premium is 9. Whether
this particular premium has bearish or bullish implications depends on whether it falls
in the range of sell programs, no programs, or buy programs.
These program ranges are delineated by the five premium values of sell active, sell
threshold, fair value, buy threshold, and buy active, which are described below.
These five significant values are mathematically determined; an equation for
"fair value" is presented in the Help Pages.
Additional information about sell and buy
programs and the associated five significant values of the futures-spot premium are given below:
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Sell Programs
A sell program is the simultaneous (short)
sell of all (or almost all) the stocks in
the index (in weighted proportions) and the
purchase of the index's futures contract.
If the sell program is of sufficient magnitude,
the stocks comprising the index will decline
and, correspondingly, the index's futures
contract will rise, producing the effect
of a stock market decline and a futures market
rise.
A sell program condition arises when the
"futures - spot" premium shrinks
significantly below fair value. This can
happen because the futures and equity markets
move independently and, in this case, either
the futures contract has moved sufficiently
lower and/or the spot index has moved sufficiently
higher, relative to each other. [The spot
index moves higher when one or more stocks
in the index increases.] If the resulting,
shrunken premium reaches the sell threshold,
an index arbitrageur can capture a riskfree
profit by executing a sell program. The short
stock position and long futures position
can be held either to the futures' settlement
(expiration) date (at which time the premium
imbalance is contractually guaranteed to
have disappeared) or to an earlier date when
the premium imbalance has disappeared due
to market action.
In a typical sell program, the stock sales
are short sales. The resulting proceeds are
invested in fixed income instruments whose
interest belongs wholly or partially to the
arbitrageur, according to a pre-arranged
short interest rebate agreement with the
stock lender.
Two significant values in the sell program
range are the sell active and the sell threshold values, described below: |
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No Programs
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Buy Programs
A buy program is the simultaneous purchase
of all (or almost all) the stocks in the
index (in weighted proportions) and the sale
of the index's futures contract. If the buy
program is of sufficient magnitude, the stocks
comprising the index will rise and, correspondingly,
the index's futures contract will decline,
producing the effect of a stock market rise
and a futures market decline.
A buy program condition arises when the "futures
- spot" premium expands significantly
above fair value. This can happen because
the futures and equity markets move independently
and, in this case, either the futures contract
has moved sufficiently higher and/or the
spot index has moved sufficiently lower,
relative to each other. [The spot index moves lower when one or more
stocks in the index decreases.] If the resulting, excessive premium reaches
the buy threshold, an index arbitrageur can
capture a riskfree profit by executing a
buy program. The long stock position and
short futures position can be held either
to the futures' settlement (expiration) date
(at which time the premium imbalance is contractually
guaranteed to have disappeared) or to an
earlier date when the premium imbalance has
disappeared due to market action.
Two significant values in the buy program
range are the buy threshold and the buy active values, described below: |
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Sell
Active (SA) |
Sell
Threshold (ST) |
Fair Value
(Premium) (FV) |
Buy
Threshold (BT) |
Buy
Active (BA) |
This is the "futures - spot" index
premium value at which sell programs should
be prevalent, thereby producing a meaningful
decline in the stock market.
Sell program arbitrageurs will realize different
rates of return on the investment of the
proceeds of their stock short sales. Nevertheless,
at this extreme premium level, one can expect
numerous arbitrageurs to execute sell programs,
causing the premium between the futures and
equity markets to increase and, thereby,
correcting the prior imbalance.
Yet, just because compelling premium values
exist, it does not automatically mean that
arbitrageurs will execute sell programs.
Sell program activity might not occur for
a variety of reasons such as arbitrageurs
being fully committed or awaiting even more
favorable conditions. |
This is the minimal "futures - spot"
index premium value at which sell programs
might be initiated. So, some sell programs
are possible and this could cause a stock
market decline.
The sell threshold will vary among arbitrageurs
due to several reasons, four of which are
covered here. First, it may not be possible
to execute simultaneously the two legs of
the arbitrage, so some allowance must be
made for slippage and this will vary among
arbitrageurs. Second, trading commissions
will vary. Third, sell program arbitrageurs
face different rates of returns on the investment
of the proceeds of their stock short sales.
Specifically, the interest rates and the
percentage amount of rebated interest vary
among arbitrageurs and their stock lenders.
Fourth, arbitrageurs will make different
estimates of the dividends that must be paid
to the stock lender during the program's
duration
Therefore, the magnitude of the premium needed
to meet individual arbitrageur's profit requirements
and to trigger sell programs will vary. |
This is the "futures - spot" index
premium value at which the futures and the
equity markets are in equilibrium.
No (profitable) index arbitrage type programs
will occur at fair value nor when the "futures
- spot" premium level falls within the
range extending from the sell threshold to
the buy threshold.
This absence of program activity is the usual
state of the relationship of the futures
and equity markets: even though they operate
independently, their general movements are
correlated and, hence, program trading opportunities
are usually not present.
Definition
In words, the fair value premium is equal
to the interest that could be earned on the
index minus the relevant stock dividends
occurring during the program's duration,
which is the time from a given date until
the futures' settlement (expiration) date.
An equation for fair value is presented in the Help Pages. |
This is the minimal "futures - spot"
index premium value at which buy programs
might be initiated. Thus, a limited number
of buy programs could occur, possibly causing
a stock market rise.
The buy threshold will vary among arbitrageurs
due to several reasons, four of which are
covered here. First, it may not be possible
to execute simultaneously the two legs of
the arbitrage, so some allowance must be
made for slippage and this will vary among
arbitrageurs. Second, trading commissions
will vary. Third, buy program arbitrageurs
have different costs of capital in which
to finance their stock purchases. Fourth,
arbitrageurs will make different estimates
of the dividends that will be captured during
the program's duration.
Therefore, the magnitude of the premium needed
to meet individual arbitrageur's profit requirements
and to trigger buy programs will vary. |
This is the "futures - spot" index
premium value at which buy programs should
be prevalent, thereby producing a meaningful
rise in the stock market.
Although arbitrageurs incur different costs
of capital in financing the purchase of the
stocks that comprise the index, numerous
buy programs should be launched at this extreme
premium level. The impact of these buy programs
would be to reduce the premium between the
futures and equity markets, thereby providing
a self-correcting influence.
Yet, just because compelling premium values
exist, it does not automatically mean that
arbitrageurs will execute buy programs. Buy
program activity might not occur for a variety
of reasons such as arbitrageurs being fully
committed or awaiting even more favorable
conditions. |
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