Indices and their underlying basket!

[Victor90]

Hi!
This might seem like a stupied question but really wanna know if i got it right. The traded indices are futures of an underlying basket of stocks. So the price of a indices should be based on the sum of the indivudal stocks in the basket. But since the futures is traded free doesnt that mean that sometimes there will be diffrencies in the price of a indice and its underlying stock basket? Or is that taken away by arbitrage trading? If so? How big is that industry, buying the basket and selling the indice or reverse? I presume that its nothing for retail traders becuse of the competion against the banks are too hard. Is that right?

 

[Rhody Trader]

The traded indices are futures of an underlying basket of stocks. So the price of a indices should be based on the sum of the indivudal stocks in the basket.

Basically correct, though there are a number of different ways an index can be calculated. For example, the Dow and S&P use different methods.

But since the futures is traded free doesnt that mean that sometimes there will be diffrencies in the price of a indice and its underlying stock basket?

Yes, price divergences can arise.

Or is that taken away by arbitrage trading?

The arbs definitely come in to pull the futures and cash index (and ETFs, options, etc.) back in line when it drifts.

If so? How big is that industry, buying the basket and selling the indice or reverse? I presume that its nothing for retail traders becuse of the competion against the banks are too hard. Is that right?

Definitely not a game for the retail trader. It takes big bucks to be able to do the arb. Think about how big a futures contract is in valuation (price x point value) and you get a picture of how much money would be needed to do the cash side of the trade. For example, if the S&P is at 800, then the S&P contract value is $200,000 (800 x $250). Even if a retail trader had the scratch to do that kind of arb, the institutions have lower transaction costs, so they can do it profitably at narrower spreads than the retailer trader could.

 

[A Dashing Blade]

+ bear in mind that the index is calculated using mid prices, there's allways a bid/offer spread on the underlying equities.

 

[Rhody Trader]

+ bear in mind that the index is calculated using mid prices, there's allways a bid/offer spread on the underlying equities.

Actually, I believe indices are calculated using traded prices, not indicative ones. But your point holds in terms of needing to factor in the spread when contemplating doing an arb.