Tuesday, December 04, 2007

The Stock Index Futures Premium as a Sentiment Measure

A reader recently inquired about my use of the S&P emini stock index futures premium as a market indicator. The premium, which in e-Signal goes by the symbol $EPREM, represents the difference between the S&P 500 emini index and the S&P 500 cash index. When traders are bullish and buying the futures this premium will expand; when they're bearish and selling the futures, the premium collapses.

In practice, there are bounds to how much the premium expands or collapses. If the premium goes too far above (below) fair value, arbitrageurs will sell (buy) the futures and buy(sell) a corresponding basket of stocks to capture the price differential.

The chart above, which depicts the last 90 minutes of trading for Tuesday, December 4, tracks what I call the Adjusted Premium. Here, instead of comparing the current premium value to fair value, I simply subtract a 2 hour moving median of the premium from each subsequent premium value. Hence, a negative number means that the current 1 minute closing premium is below the 120 minute O-H-L-C median; a positive number means that the current closing premium is above the 2-hour median value.

What I look for with the Adjusted Premium is:

a) How much time is spent above vs. below the zero line as an ongoing sentiment gauge. Readers will recognize that this is also how I evaluate the Adjusted NYSE TICK. I'm looking for shifts in sentiment over time--changes in the distribution of the Premium.

b) How strength or weakness in the Adjusted Premium is associated with price movement. Elsewhere, I've referred to this as "efficiency": the degree to which a unit of sentiment can move the market price directionally.

You can see that about midway on the chart, we had sustained positive Adjusted Premium readings followed by a price high that was not confirmed with a strong Adjusted Premium reading. We quickly returned to the prior trading range, suggesting inefficiency: the buying sentiment could not sustain a directional upward move.

The reason for this is that the buying of stock index futures may or may not represent a directional bet on the part of large traders. They might buy the futures because they're bullish on stocks. Alternatively, they could buy the futures (and temporarily raise the premium), but simultaneously sell stocks or specific stock sectors. When the buying or selling of futures does not express directional bets on the part of large traders, we typically won't see a trending move.

That's what happened with about 45 minutes left in Tuesday's session. There was buying in the futures, but the bullish sentiment could not sustain higher prices. We returned to the prior trading range and proceeded to retrace the day's range. As a rule, when we see extreme buying or selling sentiment (whether in the Adjusted Premium or Adjusted TICK) unable to bring the market to new highs or lows, it's worth fading that sentiment, as buyers/sellers are forced to cover their positions.

In a bull market, sentiment pullbacks will occur at successively higher lows. In a bear market, sentiment bursts will occur at successively lower highs. In a range market, such as we saw on Tuesday, we see sentiment bursts and pullbacks at range extremes, but unable to keep the market out of that range. It's those sentiment-based false breakouts from ranges and subsequent returns to the value areas of the Market Profile that make for some of the best countertrend trades.


S&P eMini Premium and Divergences