A Useful Trading Tip from the World of Futures and Options

At the start of each day, traders want to capture the market mood and opening indicators.  At the end of the day anyone who is a regular market follower wants to know what happened.

A Great Example from Last Week

Experienced traders know that futures trading affects stock trading.  Those scoring at home may not get an accurate account of why the futures moves are important.  Here is some insight from Adam Warner’s Daily Options Report, one of our daily reads (and now added to our list of featured sites).  Take a look at Adam’s analysis and then come back for our take.

The concept of fair-value in regards to futures/ETF trading is something that has never made it’s way to Bubblevision.

So
last night after hours the SPY and S&P futures tanked. Since the
SPY regular session closes at either 4:15 or 4:20 (I never remember
which), there can be some disparity with the *cash* S&P if you get
a big move between 4 and 4:15.

Which we did yesterday.

Why this is important to you….

Many big-time traders have positions in the OEX, hedged with futures, the OEX basket, or another position that has been selected to confer a trading edge.  Some of these positions are highly leveraged, especially if they normally trade as a strict arbitrage.

There is one time each day when the arbitrage can be upset — from 3:00 to 3:15 Central Time (chosen because Chicago is the center of both futures trading and OEX options).  Something very interesting happens.  The stocks that make up the OEX stop trading at 3:00.  The futures and options continue trading until 3:15.  This means that for fifteen minutes there is the potential for a big discrepancy.

When there is a big move in the futures during this time — the sort that Adam highlights — it presents either an opportunity or a risk for the OEX trader.  Suppose you have a position with deep calls (in the money and with little premium over parity).  If the futures trade down, you can elect for an early exercise of your calls and collect the cash settlement price from 3:00.  You can then flatten out our position by buying futures.

On the other side of the trade there is someone who is short the in-the money (ITM) call.  That trader is aware of assignment risk.  When some exercise options, the system determines (a process beyond the scope of this article, but more or less randomly) specific clearing firms and traders who will be "assigned".

That means that the trader shows up in the morning only to learn that he had a major short position the night before, and now it is gone.  An astute trader may see this happening the day before and try to guess the percentage of the assignment, but it is pretty tough to do.

If the futures trade up during the fifteen minute period, the opposite effects happen.  Those with short puts may be assigned.

Conclusion

We realize that this analysis may seem technical and a lot of "inside baseball" on options trading.  Let us summarize what it means for the average trader.

1. When futures trade down dramatically in the fifteen minute period after the market closes, the market is likely to be heavy the next morning — even if the futures come back!  That is because the assigned traders need to replace their shorts.  (The opposite occurs when futures trade up.)
2. When one is interpreting the reaction, one needs to keep this in  mind.  It is what Adam describes, but exaggerated, because of the early exercise and assignment.
3. You will never see any of this explained on TV, but it is important for reading the market.
4. Companies should avoid making earnings announcements before 3:15 (4:15 EDT) but sometimes they do not.  There is a general perception that they are announcing after the close.  There are also other news events that hit during this  time.

Understanding options and futures is important for all traders, even those who do not trade these instruments.  Thanks again to Adam for highlighting something that we watch every day, but many others do not.