today, buy the futures contract, and take delivery of the commodity later
at a lower price—in essence, earning a return on goods that would be in
storage anyway.
Such a process of buying and selling commodities against their fu-
tures contracts is one type of arbitrage. Arbitrage involves traders who
take advantage of temporary discrepancies in the prices of identical or
nearly identical goods or assets. Those who reap profits from such
trades are called arbitrageurs.
Arbitrage is very common in both the stock index futures market
and the ETF market. If the price of futures contracts sufficiently exceeds
that of the underlying S&P 500 Index, it pays for arbitrageurs to buy the
underlying stocks and sell the futures contracts. If the futures price falls
sufficiently below that of the index, arbitrageurs will sell the underlying
stocks and buy the futures. On the settlement date, the futures price
must equal the underlying index by the terms of the contract, so the dif-
ference between the futures price and the index—called a premiumif it is
positive and a discountif it is negative—is an opportunity for profit.
Arbitrage in the ETF market is similar, except here an arbitrageur
must buy or sell all the stocks in the index and simultaneously make an
offsetting transaction in the ETF in the open market. An arbitrageur in the
ETF makes a profit when the prices of the stocks that she buys to create
the ETF are less than the funds that she receives by selling, or creating, an
ETF. Alternatively if the prices she receives from selling the stocks in the
index exceed the cost of buying the ETF, the arbitrageur will buy the ETF,
exchange it into its component stocks, and sell them in the open market.
Index arbitrage has become a finely tuned art. The prices of stock
index futures and ETFs usually stay within very narrow bands of the
index value based on the price of the underlying shares. When the buy-
ing or selling of stock index futures or ETFs drives the price outside this
band, arbitrageurs step in, and a flood of orders to buy or sell are imme-
diately transmitted to the exchanges that trade the underlying stocks in
the index. These simultaneously placed orders are called programmed
trading, and they consist of either buy programsorsell programs. When
market commentators talk about “sell programs hitting the market,”
they mean that index arbitrageurs are selling stock and buying futures
or ETFs that have fallen to a discount.
PREDICTING THE NEW YORK OPEN WITH GLOBEX TRADING
Although trading index futures closes at 4:15 p.m. Eastern time, 15 min-
utes after the close of the New York stock exchanges, trading reopens in
258 PART 4 Stock Fluctuations in the Short Run