Relationship between cash and futures markets

[femi73]

Hello all, can someone explain the relationship between the cash market and the futures. Why do futures move before cash?..if futures are derivatives why do they move first.?..if this sounds like a dumb question, then pardon my ignorance because i need closure to this. Its making me confused

 

[roguetrader]

Hello all, can someone explain the relationship between the cash market and the futures. Why do futures move before cash?..if futures are derivatives why do they move first.?..if this sounds like a dumb question, then pardon my ignorance because i need closure to this. Its making me confused

Very basically the futures market represents the speculative market for the underlying, therefore as traders speculate as to the direction and magnitude of a move in a particular index so the futures will move first.

 

[mjward]

The difference between futures price and spot price is what is known as basis. The size of this basis depends on a whole heap of things that would be better described in a book than by myself. But very basically, spot prices should incorporate all past and present information regarding the underlying and should also account for growth etc. Futures prices are different because as roguetrader stated, their pricing is also based on market speculation to a greater degree than spot.

For example, latest news reports that a BP oil tanker has sunk. BP spot may drop by 10 points but BP 3m Futures by only 5 (basis thus 5). This is because speculators may think that in 3 months time oil supply will be less affected by this event than the current performance which is reflected in the spot.

 

[a_gnome]

The difference between futures price and spot price is what is known as basis. The size of this basis depends on a whole heap of things that would be better described in a book than by myself. But very basically, spot prices should incorporate all past and present information regarding the underlying and should also account for growth etc. Futures prices are different because as roguetrader stated, their pricing is also based on market speculation to a greater degree than spot.

For example, latest news reports that a BP oil tanker has sunk. BP spot may drop by 10 points but BP 3m Futures by only 5 (basis thus 5). This is because speculators may think that in 3 months time oil supply will be less affected by this event than the current performance which is reflected in the spot.

There is actually an arbitrage relationship between any spot and futures market. For stock index futures for example the future is more expensive than the spot by the difference between the prevailing risk-free interest rate that you gain by not having to buy the spot and the dividend yield that you lose by not owning the spot. If the relationship between spot and future gets out of line arbitrageurs will step in to buy the cheap one and sell the expensive one.

In your example the arbitrageurs will buy the spot BP at -10 and sell the futures at -5 until they get back into line at which point they will unwind the trade. Since this is a risk-free trade (at expiry the two are guaranteed to be in line) they usually do large size.

All futures markets will have similar relationships though for some markets such as the agricultural ones the basis depends on things like the costs of storage / delivery of the crop.

Hope this helps.

 

[Anonymous]

What do you mean by "futures move before cash?"

 

[blackcab]

Take YM as an example, what moves it and how much of the following is true/false? You've got :-

1. YM itself - might or might not move in response to being bought/sold. Some trades are in response to movements in the constituent shares (the underlying) or the big Dow -- i.e. arbing. Some trades are unrelated to movements in the underlying or the big Dow, e.g. trading YM price movement outright or hedging.

2. Full Dow contract - pit traded; how much does it influence YM - only through arbing?

3. Individual constituent shares - can be bought/sold for their own reasons or individually/collectively to arb against the full Dow or YM.

When a Dow stock goes up (and in doing so raises the (untradeable) DJIA underlying cash index by 10pts), what happens to YM? Do people buy YM because for a few milliseconds it's 10pts "too cheap"? If so, the underlying leads the futures and the arbers keep everything in line.

Alternatively if there's a ton of buying on the YM, for whatever reason (perhaps so many people bought YM in reaction to that one stock pushing DJIA up 10pts that buy/sell pressure took YM up 20pts, or perhaps there were just a few massive buy orders taking it up 20pts), and so YM goes up 20pts while the constituent stocks are flat, what happens? Presumably the arbers buy the stocks individually, or as a basket to make the stocks (ie the DJIA) catch up. If they buy the stocks as a basket, what do they use as the basket -- the YM? (That wouldn't make sense.)

Or do the arbers instead sell the YM because its 20pt rise was not supported/reflected/caused by price movement in the indivdual stocks (collectively, the DJIA).

Are there definitive answers to these questions? Or does all the above, plus more, happen simultaneously, by different players, so that conflicting trades fly around all the time and the net result is usually pretty much in line?

(20 points. 45 mins allowed.)

 

[Bernard_Chumley]

There is actually an arbitrage relationship between any spot and futures market. For stock index futures for example the future is more expensive than the spot by the difference between the prevailing risk-free interest rate that you gain by not having to buy the spot and the dividend yield that you lose by not owning the spot. If the relationship between spot and future gets out of line arbitrageurs will step in to buy the cheap one and sell the expensive one.

In your example the arbitrageurs will buy the spot BP at -10 and sell the futures at -5 until they get back into line at which point they will unwind the trade. Since this is a risk-free trade (at expiry the two are guaranteed to be in line) they usually do large size.

All futures markets will have similar relationships though for some markets such as the agricultural ones the basis depends on things like the costs of storage / delivery of the crop.

Hope this helps.

How are you going to trade the cash FTSE???

 

[danfreek]

How are you going to trade the cash FTSE???

you don't,

you can take arbitrage trades based on different expiry months, or using an ETF or basket of stocks etc.

 

[charliechan]

futures move first because it is cheaper to transact in the futures markets, and due to the differences in regulations between futures and cash markets.

you see - its really a simple business reason, not rocket science which many people try to make the business out to be.

besides it would be a mistake to say futures ALWAYS lead cash.

 

[Anonymous]

I still don't understand what the question means by "futures move before cash", it's as confusing as egg first or chicken first.

 

[a_gnome]

you don't,

you know that the future should expire at the cash value (although this isn't always the case as June expiry proved) so if the future get's out of line with the cash, then you take the trade that will profit from a correction in the valuation, you might have to wait until expiry, but you know the two should come back into line.

I'm afraid that won't work. If the futures are 10 pnts too expensive then you sell them. Unless you hedge you might find that the whole market rises by 200 pnts against you before expiry. The 10 pnts "profit" that you notionally have is not much use if you are not hedged. For the FTSE the arbers actually usually buy a small basket of stocks that tracks the cash market pretty well. For this reasons the markets have to be sufficiently out of line for it to be worth their while to put on the relatively expensive hedge.

For many US markets there are actually ETF's that you can use to hedge now so in the YM example blackcab wrote about you also have the Dow ETF's (who's symbol name escapes me at the moment but is something like DJI) as part of the picture.

 

[danfreek]

Yes, of course, should've thought more carefully. You do need the other side of the trade.

 

[blackcab]

Take YM as an example, what moves it and how much of the following is true/false? You've got :-

1. YM itself - might or might not move in response to being bought/sold. Some trades are in response to movements in the constituent shares (the underlying) or the big Dow -- i.e. arbing. Some trades are unrelated to movements in the underlying or the big Dow, e.g. trading YM price movement outright or hedging.

2. Full Dow contract - pit traded; how much does it influence YM - only through arbing?

3. Individual constituent shares - can be bought/sold for their own reasons or individually/collectively to arb against the full Dow or YM.

When a Dow stock goes up (and in doing so raises the (untradeable) DJIA underlying cash index by 10pts), what happens to YM? Do people buy YM because for a few milliseconds it's 10pts "too cheap"? If so, the underlying leads the futures and the arbers keep everything in line.

Alternatively if there's a ton of buying on the YM, for whatever reason (perhaps so many people bought YM in reaction to that one stock pushing DJIA up 10pts that buy/sell pressure took YM up 20pts, or perhaps there were just a few massive buy orders taking it up 20pts), and so YM goes up 20pts while the constituent stocks are flat, what happens? Presumably the arbers buy the stocks individually, or as a basket to make the stocks (ie the DJIA) catch up. If they buy the stocks as a basket, what do they use as the basket -- the YM? (That wouldn't make sense.)

Or do the arbers instead sell the YM because its 20pt rise was not supported/reflected/caused by price movement in the indivdual stocks (collectively, the DJIA).

Are there definitive answers to these questions? Or does all the above, plus more, happen simultaneously, by different players, so that conflicting trades fly around all the time and the net result is usually pretty much in line?

(20 points. 45 mins allowed.)

Any thoughts on this?

 

[Anonymous]

1. YM itself - might or might not move in response to being bought/sold. Some trades are in response to movements in the constituent shares (the underlying) or the big Dow -- i.e. arbing. Some trades are unrelated to movements in the underlying or the big Dow, e.g. trading YM price movement outright or hedging.

2. Full Dow contract - pit traded; how much does it influence YM - only through arbing?

3. Individual constituent shares - can be bought/sold for their own reasons or individually/collectively to arb against the full Dow or YM.

A player may buy a constituent share because of increased dividends. With sufficient buying pressure on the constituent shares the index goes up. A player may sell the constituent share because of x-d. With sufficient selling pressure index goes down.

When people walk around in the street in Chicago or munching away in the coffee shops in the alley in New York, and they hear rumours that a constituent stock is falling they sell some more. An arber sees the difference between the constituent stock and its Single Stock Futures rubs his hands in glee and starts to eat the spread.

As more sell constituent stocks index falls and falls, punter with big account but doesn't know what's going on calls broker and sells all he can. Index plunges towards the core, horror, panick, volatility sets in, index, full Dow and YM jumps up and down in schizophrenic frenzy. Horror, panick, "What to do? What to do?" the inexperienced run around as they see their positions mount up losses after losses.

Arber sees the difference between full Dow and YM rubs his hands in glee, "Hee! Hee! Hee!"

What drives what? Who knows.

(A few days taken, over or under 3 points?)

 

[blackcab]

I guess my question is - how much does YM trading (rather than constituent, SSF or big Dow trading) affect YM price?

If every YM trader took a day off and YM was completely untraded, but trading in constituents was as normal, what would you expect the YM chart to look like? Just like it would if it were being traded normally, a little different, or really quite different?