The ES E-Mini contract is the hedging and speculation vehicle for the SPX (the Cash S&P 500 index).

The SPX index is the cash value of the 500 physical stocks combined. As stocks are physically bought and sold, the SPX index is updated to reflect a stable price effect or a movement up and down.

The futures contract will normally be trading at a premium to the cash market to reflect the carrying costs and the expected dividends over the life of the futures contract.

The premium difference between the futures and the cash has what is termed a “fair value”. The fair value changes each day as you move closer to contract expiry, based on the value of the cash SPX.

Nevertheless, at times, the futures accelerate up and down and begin to run ahead of the cash market due to speculator activity. This is when the “premium” can increase or contract out of the normal from fair value.

Program trading has a huge effect on events whenever the premium of the futures rises or falls by a specific amount; it causes massive volume to enter the market to take advantage of the discrepancy.

Large traders, brokerage traders and institutions will sell futures contracts and buy selected physical stocks simultaneously when the premium rises to a high and conversely will buy futures contracts and sell physical stocks when the premium drops to a low.

For instance, if the fair value (FV) for the day is 4.48, and the buy threshold (BT) is 3.27, and the buy arbitrage (BA) is 2.37, the buying programs will be activated at these levels. On the same day, say the sell threshold (ST) is 5.73 and the sell arbitrage (SA) is 6.67, the sell programs will be activated at these levels.

The idea behind their method is to buy futures and sell stocks around the BA levels and then reverse position by selling futures and buying stocks when the premium change reaches SA. By doing this, they theoretically pocket the difference between the premium low and high.

The effect of these activities on the futures contract is, at times, quite dramatic as the volume suddenly floods into the market. You can see this happening on a 2- or 3-minute chart of the ES if you monitor the volume bars.

At times when the market is thrusting in one direction or the other, the volume bars will spike up and then the next volume bar will subside as there is exhaustion on one side or the other. This normally has the effect of causing a reaction in the futures back the other way. It could also signal a complete change in the intraday direction if other important criteria are met at the same time.

If you monitor the premium changes in conjunction with the volume bars, you will witness the programs coming into play. In this last case, the programs were not activated, so the volume was coming from elsewhere.

I have my own unique software to monitor the volume to see if it is coming from program trading. I can upload the FV, BT, BA, ST and SA values each day with a couple of mouse clicks and run my eSignal Formula Script (EFS) file below my ES chart in 5- or 3-minute time frames.

 *Reprinted (and modified) with permission from Bryce Gilmore