Friday, February 1, 2008

Outperform S&P500 with S&P500 futures, Part 1

The S&P 500 futures contract comes in two sizes – S&P500 (SP) or e-mini S&P500 (ES). The SP moves by $250 for every 1 point move in the underlying index, while the ES moves by just $50. Thus if the futures are trading at 1330, if you buy one SP contract you are basically buying 250*1330= $332,500 worth of stocks. When you buy one ES contract, you are basically controlling one fifth of the large contract or $66,500. Another major difference in both contracts is the fact that the large one is traded primarily on the floor of CME, while the e-minis are traded electronically, almost around the clock. The contracts always expire on the third Friday of each March, June, September and December.

The futures do not pay dividends, but they also trade at a premium to the S&P 500 index, which declines as the index reaches its expiration day. The beauty behind trading the e-minis is that to trade one contract, you need to put only 4,000-5000 dollars in collateral. Thus, for less than 10% of the underlying contract value on the ES, you can participate in any upside/downside movements of the index. Thus if you had $66,500, you could simply buy one contract, put around 10% for margin requirements and then have 60,000 dollars in cash sitting idle. You earn money on the margin requirement because you have put the funds in a money market fund. With the remaining $60,000 though, you could create a bond/ CD ladder in order to make money from interest yields. The drawback is that you must trade 4 times a year in order to be fully invested in the index, because the contract expires every quarter. Most brokers allow you to trade the e-minis for as little as $2.40 per contract, which is less than trading $66,500 worth of SPY for example. Another drawback is that the index is settled every day, which means that if the S&P500 futures decline by 10% from your initial purchase at 1330, you will have to deposit and extra 133*50=6650 dollars to your account, otherwise you will get a margin call.

On December 31, 2007 the E-mini futures closed at 1477.25, while the S&P 500 index closed at 1468.36. The dividends during 1Q 2008 are expected to be around 7 points. Thus investors would have to achieve around 16 points in interest income just to break even. In order to achieve 16 points from interest, you need to have interest income of around 1.08% per quarter, which is 
an APY of 4.37%. 

Any yield that the investor can achieve above 4.37 % APY would result in him/her outperforming the index. In today’s environment of rapidly declining interest rates though, it might not be possible to outperform the market using S&P 500 futures.

Using the interest rates from this website i was able to construct the following ladder ( on your left).

Assuming that interest rates decline, one would be able to outperform the S&P 500 slightly, assuming that the index does not fall more than 30% from its recent levels over the next 3 months and that interest rates decline below 4%. An analysis of the percentage draw downs in S&P 500 from its relative all-time highs could be very beneficial when constructing the ladder.

Tomorrow I would post my ideas on outperforming the market using an enhanced strategy.

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