Since You Asked
| Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. | 
Don Bright of Bright Trading |
UNDERSTANDING SPOOS PREMIUM
I have been researching the PREM ("premium") or spread between the SPOOS and the S&P cash index. I am trying to understand it better to help in speculating day-to-day market direction. Can you shed some insight into this? --Argula
Good question about a very valuable tool that is necessary for every trader's toolbox. First off, the Standard & Poor's 500 spot price, generally reflected with a symbol of SPX, is the actual index price for all 500 stocks (just like the Dow Jones Industrial Average is for the Dow 30 stocks). The SPOOS, as we call them, are the S&P 500 futures contract, interchangeable with the emini contract (smaller contract based on same 500 stocks).
Now, let's assume you were going to buy all 500 stocks for cash. You would be losing the interest money you would have received, or if you had to borrow money to buy all those stocks, you would have to pay interest on that money. Either way, we call this amount the "cost of carry." This is the cost to hold those stocks. In lieu of buying all the stocks, you could simply buy the futures contract for much less money, due to the leverage involved. So if you were to buy the futures contract instead of the stocks, you would be willing to pay a premium over the current spot price to compensate for the interest you are not paying. This is called the "fair value" (FV) for the futures. For example, if the spot price is 1283 and the cost of carry is 2.00 (for the time period until the next quarterly expiration of the futures contract), then the futures should trade at 1285 (all other market factors being equal). If the futures are actually trading at 1289, then the premium to fair value would be four S&P points, indicating a higher opening of the overall market (we are assuming the premarket opening time frame). For comparison, the Dow industrials would likely open up approximately 30-35 points.
Let's take this one step further. During the trading day, the futures will trade around fair value, but venture into either premium or discount territory. This is the amount above or below the valuation where they should trade if the market were flat. This premium or discount to fair value means that the floor traders and program traders (and other arbitrageurs) will sell the futures above fair value (and perhaps buy a basket of stocks to hedge themselves, or even buy all 500 stocks at times), and buy futures below fair value and reverse their stock positions. This allows for locking in a profit (theoretically).
So the premium (or discount) shows the short-term movement of the intraday market. The symbol PREM (on most datafeeds) is the difference between the future and the spot price, but you must consider the fair value cost of carry to give yourself a valuable number.
You may want to consider going to www.programtrading.com for a detailed formula.
Hope this helps!
ABOUT STOP-LOSS ORDERS: A MESSAGE-BOARD CONVERSATION
I have read/heard that sometimes the retail trader's stop-loss and target orders can be seen by other traders (though not at-home traders). Is this true? As a result, your positions can be stopped out by market makers, I assume. Is this a situation only from the "old days," or is it present day also? If so, is it isolated to a few markets or most in general? I'd think electronic markets are somewhat invisible. Just curious--Trader Guy 02
I sit with 100 other professional traders, and each and every one also speaks of a "they" out there who is responsible for the losses, stops, and so on -- "they" this, "they" that, all day long.--Rhymeswithorang
I have to agree with you both. For 30 years, "we" have been "they" -- and we don't see anything! Many stops are held by the retail broker, so they "see" them. For insight into how market makers may use what they "see," check this out for some insight: www.stocktrading.com/wsjknight1.shtml
Since the retail trader only accounts for single-digit percentage volume on the exchanges, I wouldn't worry too much about market makers or specialists. On the other hand, we teach our people to only use alerts and never place stop orders (for several reasons).
Could you please elaborate on these reasons? -- Math_Wiz
The primary reason I don't use actual stop orders is that I want to "see" what the market is doing when the alert goes off. Was it a bad print, was it a negotiated trade that generally bounces back, was it a trade-through (when a stock prints at a price that is outside the quoted bid/offer prices)? Is it news related, sector related, disaster related-is there another stock that I should buy or sell to hedge vs. cover a losing trade? This is all part of tape reading. Stop orders are generally best used only by investors who cannot sit and watch the market all day. Hope this helps.
E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
Originally published in the May 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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