How the Cash Market Indices Influence the Path of the ES E-Mini
By Bryce Gilmore of www.wavetrader2004.com*
Posted: May 19, 2006
I have found in the past that many newcomers to trading the ES futures have little or no idea of how they can improve their approach to trading the S&P.
What I am about to show you is fundamental to your success in trading the E-Mini contract.
The S&P 500 is a capitalization index made up of 500 stocks of varying capitalization values ranging from 381 billion down to 1 billion. These are commonly referred to as "blue chips" and "mid-caps". The way the index is calculated means the price movements in the higher capitalization stocks (the blue chips) have a greater influence on the fluctuations in the price of the S&P 500 (SPX).
The blue chip content of the S&P 500 is represented by the OEX, which is the top 100 stocks, and these account for approximately 66 percent of the total value of the SPX. The balance of the S&P 500 is fairly represented by the MID, the mid-cap 400 index.
It goes without saying that any fast rise or fall in the OEX will quickly flow through to the SPX and send the ES along its merry way. Therefore, it is imperative that you monitor the progress of the OEX because it also trades technically and is the subject of continued program trading by the professional trading and investment houses. Program trading recently accounted for greater than 60 percent of the daily volume in the S&P market.
Now, what happens with program trading is that professionals will buy or sell large quantities of futures contracts and, at the same time, execute the reverse transaction with large quantities of physical stock. This is known as arbitraging the fair value between the futures and the cash index.
As the futures move along, they often get out of step a little with the cash SPX by racing ahead of it when going up or down. As they do this, the fair value between the futures and cash gets out of kilter. Usually, when going up, the premium can expand a couple of points above fair value, and, when going down, it can contract a couple of points below fair value.
As a result, the premium movement will activate the buy and sell programs, and the market will become flooded with massive volumes of orders in the reverse direction of the current market flow. This phenomenon has the effect of exhausting the normal buyers or sellers in the futures market and often causes the futures market to reverse direction, at least for a short time, and, sometimes, for a substantial amount of time.
When the programs come in selling near a double top, it has the effect of draining the necessary force that would be required to push the market price through the implied resistance. Conversely, when the programs come in buying near a double bottom, it has the effect of supporting the market at the time.
If you bear all this in mind, and we then go back to the relationship that exists between the OEX stocks and the overall SPX, you will begin to understand how you can improve your chances for trading the ES E-Mini.
The best way to improve your chances of trading the ES is to monitor the OEX, MID and SPX in the same time frames as your ES.
If they are all heading in the same direction, the trend will be strong. If, on the other hand, the MID is going up, and the OEX is going down, the downside will be the favored direction, yet the move will be less powerful.
There are all sorts of trading systems used in the market, but most of them do not have the accuracy for identifying the actual reversal levels in the marketplace. The market price gravitates between implied support and resistance as a general rule, yet, on a strong move, the market will bust through support and resistance like a knife through soft butter. As traders, we must continually monitor implied support and resistance and follow the price action as the market either breaks through them or reverses back the other way.
The only way to do this is with specialized software designed for that purpose.
With all the activity of the swing traders, the trend traders and the program traders, you need to know when the majority of them are going to cause the other side some grief and force them to bail out of positions.
When one side (buyers or sellers) become unarguably wrong, the market will run quickly in one direction. These are the times when you can make money very quickly.
Yesterday, May 1, 2006, for example, the market had been sluggish for most of the day up until 3:15 p.m. ET, and, then, some news hit the wires and caused a liquidation to begin in the OEX stocks.
If you had been watching the OEX as your primary indicator for the ES, you could not possibly have missed the opportunity to go short and, then, be sitting in the box seat.
The very next day in the OEX (after the action you see in the previous chart) also demonstrates a similar situation where, late in the day, the OEX reverses off a double bottom and leads a rally in the ES futures.
Without seeing the double bottom reversal in the OEX, it would have been difficult to understand why the ES futures reversed at the time.
But, the reason is because the Wall Street institutions are generally buyers at double bottoms and sellers at double tops in the cash markets. You have to understand that they have so much money available to them, they can force the market to do virtually anything they like for a short time. When the guys on the CME floor see what they are doing they jump on the bandwagon with them.
*Reprinted (and modified) with permission from Bryce Gilmore
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