1、An Introduction to Program Trading and Index Arbitrage,Introductory Domain Training SessionBy: Lynn Siao On: 23 Nov 2010,What is “Program Trading”?,Defined: A type of trading in securities usually consists of baskets of 15+ stocks.,What is “Program Trading”?,In practice: A type of trading involving
2、stocks, options, and/or futures based on the securities prices in relation to one another on a pre-determined basis, and not on macro- or microeconomic reasons. A “program” can be either a “buy” or a “sell” one.,What makes a program a “buy”?,You simultaneously purchase all (or nearly all) of the sto
3、cks in the index being tracked in weighted proportions. You then sell the future contract on the index.,Conclusion,You are seeing (A) the futures market for the index being overvalued relative to the stock market. You are betting (B) the index futures price will fall while at the same time, the inde
4、xs stocks prices will rise to reach equilibrium.,Example,You are trading in the S&P 500 index future contract versus the S&P 500 index (cash).,Example (Continued),You are trading in the S&P 500 index future contract versus the S&P 500 index (cash). You need to set up a “buy threshold” and a “buy act
5、ive” (or the corresponding sell numbers for a “sell” program) for your “buy” program.,Example (Continued),You are trading in the S&P 500 index future contract versus the S&P 500 index (cash). You need to set up a “buy threshold” and a “buy active” (or the corresponding sell numbers for a “sell” prog
6、ram) for your “buy” program. You calculate the Fair Value numbers at which the futures and cash markets are in equilibrium, and take the difference. (Note: This “futures cash” difference is also called “fair value”.),Example (Continued),You are trading in the S&P 500 index future contract versus the
7、 S&P 500 index (cash). You need to set up a “buy threshold” and a “buy active” (or the corresponding sell numbers for a “sell” program) for your “buy” program. You calculate the Fair Value numbers at which the futures and cash markets are in equilibrium, and take the difference. (Note: This “futures
8、 cash” difference is also called “fair value”.) If your “fair value” number hits or passes your threshold, then your “buy” program may begin.,Fair Value,Fair Value = (Interest on the index from now to the futures expiration) (Dividends divisor adjusted), or Fair Value = (Index Value) * (1 + (Interes
9、t Rate)(Number of Days Remaining in the Future Contract) / 365) 1 (Sum of Dividends) / Index Divisor,Note,There are several ways to calculate fair value!,So what makes a program a “sell”?,So what makes a program a “sell”?,Just the opposite of a “buy” program.,Shouldnt markets be efficient?,The abili
10、ty to arbitrage through a program is given due to the futures and stock markets trading independently. This leads to over- and under-pricing cases of which can be take advantage.,What is “Index Arbitrage” then?,It is a form of program trading. There are different types of index arbitrage programs, t
11、hough.,Strict definition,An index is composed of multiple stocks, and is the weighted sum of these stocks. Each stock is traded independently of one another. Each stock can react to market situations at different times (leaders versus laggers), so a leaders price can change before that of a lagger.
12、If a trader can identify the indexs leaders and laggers, this gives him the chance to take advantage of the mispricing when it happens before corrections occur.,Type of strategy,You can think of an “index arbitrage” strategy as one that is beta in nature. In other words, such a strategy is relative
13、to a benchmark (or a measure of market risk).,Note,Index arbitrage activity is rising in Asia. “Index arbitrage tends to keep the prices of index futures where they should be by taking away inefficiencies in the market. once they get a signal to buy or sell, they will execute the whole basket.” (Han
14、i Shalabi, Credit Suisse) Because of this, appropriate risk management controls will be needed.,What is “Basis Trading”?,It is a form of arbitrage trading also. You purchase one particular security and sell a similar security. Typically, this is the purchase of a security and the sale of its corresp
15、onding future contract. This is called a “cash and carry” trade. It is profitable if the purchase price + the cost of carry is less than the futures price.,Brief aside: What is “Carry”?,Definition: It is the cost of holding a position. It can be the cost of interest paid on a margin account, the cos
16、t of paying dividends (if you are short), storage costs (for physically held assets), or the opportunity cost. Typically, it is the risk-free interest rate that can be earned minus any future cash payments.,In return,To combine “program trading”, “index arbitrage” and “basis trading”, there are seve
17、ral ways.,Methods,Index ETF versus Index Future Index ETF versus Synthetic Index Cash Basket Index Future versus Synthetic Index Cash Basket And etc.,ETF,Short for: Exchange-Traded Fund Definition: A security that “holds” assets at approximately the same price as the assets “net asset value” over th
18、e entire trading day. An ETF is a cash security i.e., it trades on a stock exchange.,Example,Example (Continued),Index Future,Also known as: Stock market index future Definition: Cash-settled futures contract on the value of a particular stock market index. “Cash-settled” means that when delivered,
19、the parties exchange cash, and not the entire index itself.,Synthetic Index Cash Basket,Definition: A construct that contains the stocks in an index in the same proportions as that of the index.,Basic Example,Given: ETF that tracks 5 stocks. Index that has the same 5 stocks as its constituents, but
20、has 3 shares per stock. Each stock trades at US$20.00.,Example (Continued),The ETF, therefore, is trading at US$100.00. The index is expected then to be trading at US$300.00. If one of the 5 stocks prices drop to US$15.00, then:1. The ETFs price should be US$95.00.2. The indexs price should be at US
21、$285.00. If the price(s) do not match, then there may be an arbitrage possible. (Note: Excluding dividends and etc.),Important!,An arbitrage opportunity comes and goes very quickly. Profit on a per-trade basis is often very low e.g., in pennies, esp. for efficient and/or liquid markets. Fees and other costs can eat up most, if not all of your profits as a result.,Questions?,
