In the same way as the price of a CFD tells us nothing about the direction of the underlying stock (share), if priced efficiently, the futures price tells us nothing about the market expectations of the underlying SPI 200.

In reality, the price of the SPI 200 is simply a financing trade; the spread between the futures price and the index price reflects the cost of financing the purchase of the basket of stock underlying the index. For example, if the ASX 200 was trading at 6000 points and if interest rates were 5 % (annualised) the cost of purchasing the index including financing would be ($6000+ ($6000X5%)/4) which equates to $6075. Expiry of the SPI 200 futures is quarterly. For simplicity we have ignored dividends in this example.

Futures traders widely use the term “fair value”. Fair value simply represents the cost of purchasing the underlying constituents of the index and the inherent cost of financing. In the long run the index is generally priced efficiently due to index arbitrage, which can be defined as identifying and trading mispricings between the SPI Index and its underlying constituents.

However, in the short term, the futures price may deviate from fair value depending on supply and demand. For example, institutions with large long only portfolios may wish to sell futures to hedge their long exposure and in doing so may sell their futures down to below fair value. This presents an opportunity for traders to take the opposite side of the trade (buy futures, sell the underlyings of the index) in the belief that the futures price will return to fair value.

It is generally accepted that the price of the SPI will be a leading rather than a lagging indicator; that is that any substantial move in the cash index will be preceded by a similar move in the futures price. It should be noted that the arbitrage opportunities for supply and demand imbalances are generally too small for retail traders to benefit due to frictional costs such as commission, financing and crossing the bid/ask spread. Also if one slavishly followed the tick by tick movement of the futures price, the volatility is such that it can often give off misleading indicators.

So, in the long term (assuming efficient markets) the SPI 200 tells us nothing about the market’s expectations for the direction of the underlying S&P/ASX 200. However, in the short term, the price of SPI may offer some predictive powers of where the underlying constituents of the index as a whole may be heading on any given day.

Richard Avery-Wright

Disclaimers: The views expressed in this article are those of Richard Avery-Wright, and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.