Understanding the Auction Process

[gooni 10]

To be honest, I'm still not 100% sure I understand. For there to be an arbitrage opportunity between the futures and the cash, there is an implicit assumption (perhaps correct) that the futures can move due to factors outside of the futures themselves (such as the price of the underlying).

 

If this is the case:

 

1. Why can the futures and the cash be out of sync greater than the fair value premium?

2. Why is there an expectation that if they are out of sync greater than fair value that they will revert back to being in sync?

 

Answering "because of arbitrage traders" is not sufficient. If they can get out of sync, then the futures is a pure market and there is no guaranteed reversion back to cash. On the other hand, if the futures market automatically moves in step with cash (+/- premium) then why should it ever be out of sync?

 

The question really becomes, if the futures and cash are in sync, how is it done? Is it because market players have 'agreed' to keep them in sync? Or is it the underlying market automatically moving back to fair value (ie the actual exchange keeping them in sync?). I don't see how this would work.

 

The easiest form of the question: what is to stop a big player from holding the price up artificially in the futures as the cash crashes down?

[gooni 10]

Ignore my post above, I've worked it out. The arbitrage opportunity exists if the intention is to hold the basket of stocks (or the 'cash' index) and the futures contract until delivery. Your price for both has been locked in, and therefore you are guaranteed a profit on delivery of the future.

 

Anyone who wants to read more go here:

 

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/futurearb.htm

 

You can see that effectively there is a 'band' in which the futures will stay before they are arb'ed back in line. It is not a single value based on 'fair value' of the premium, as there are transaction and interest costs associated with buying or selling the stock basket, and there is a risk inherent in expecting dividends at certain times from certain stocks. Interesting read.

[BlowFish 10]

Gooni,

 

Harris puts forward two main sets of circumstances that give rise to arbitrage opportunities.

 

1) Slow price adjustment - here common factor values change but not all prices that depend on those factors change appropriately. Usually one or more prices are slower to change.

 

2) Uninformed traders demanding liquidity - here fundamental values are constant but uninformed traders cause prices to change as they buy in some markets or sell in other markets. Arbitrage trading connects demands for liquidity that traders make in different markets.

 

He goes on to explain how in the second scenario arbitrageurs act as risk repackagers and essentially are derivative product 'manufacturers'. Briefly if they buy the underlying and sell futures they provide long liquidity if they sell underlying and buy the futures they provide short liquidity. The arbitrage spread (the difference between the basis and fair value) is the compensation that arbitragers receive for there services.

 

As you can see if arbitragers wait for the spread to be large (so more profitable) they will likely loose out to more aggressive arbitragers.

 

Cheers.

[CandleWhisperer 10]

I didn't really know where to post this, but I am interested in the Auction Market Process.

 

First, this is really a tapestry of ideas if you will. The underlying goal, or thread weaved through out is Price discovery/ The Duel Auction Market. I believe that WRBs are areas of change in the market. As I stated in the WRB thread, I see them as Supply(sellers)/Demand(buyers) Delta zones. Of course not all WRBs are created equal. But that is for another post in another place. The Idea of a zone where changes in the supply/demand dynamic are taking place lead me to want to "drill" down and see the interaction between market participants. That is to say, to view the Duel Auction as it takes place.

 

The first chart shows that "drilling down". This is a 1 minute chart showing the market going from one that is dominated by sellers to one that is dominated by buyers. After all, At it's base level, a market moves up to find sellers and down to find buyers. As Bill Williams puts it, a markets sole purpose is to find that place where there is a disagreement on value but an agreement on price. This is why a market can not be oversold or overbought. There is always someone on the other side and price by definition is an equilibrium. Although constantly in flux.

 

Anyway, this set up happens within the range of a significant WRB from a 10 min chart. A selling bar is created at point A but there is no follow through. The Market turns up and we see a buying bar (higher high than the previous bar but not a lower low) that does have follow through. Note the open and the close of the bar. The buyers were in charge the through out that period. We open in the lower third and close in the upper third: a climber.

 

The Sellers make one more attempt to take the market down at point C. Again, there is no follow through. Notice that the market was heading down but now the sellers don't have the steam they once did: something has changed. Interestingly, we are in area of likely change (body of a WRB__).

 

The second chart has no trade set up but what I like about it is how it shows the tug of war between buyers and sellers. From a MP point of view, we go from vertical (trend) to horizontal movement (consolidation). Or out of balance into balance. Two consecutive lime paint bars create a large Balance area. I think on can actually see the bulls and the bears fighting it out. We have price rejections at the high of the balance areas, No demand bars, No supply bars, Squats, Climbers, Drifters, Market facilitation increasing (paint bars). I am I kidding myself here?