A Complete Guide to the Futures Market, 2nd Edition

CHAPTER 32

Spread Trading in Stock Index Futures

The stock market is but a mirror which . . . provides an image of the underlying or fundamental economic situation.

—John Kenneth Galbraith

■ Intramarket Stock Index Spreads

Spreads in carrying charge markets, such as gold, provide a good starting point for developing a theoretical behavioral model for spreads in stock index futures. As is the case for gold, there can never be any near-term shortage in stock indexes, which means spreads will be entirely determined by carrying charges. As was explained in Chapter 30, gold spreads are largely determined by short-term interest rates. For example, since a trader could accept delivery of gold on an expiring contract and redeliver it against a subsequent contract, the price spread between the two months would primarily reflect financing costs and, hence, short-term rates. If the premium of the forward contract were significantly above the level implied by short-term rates, the arbitrageur could lock in a risk-free profit by performing a cash-and-carry operation. And if the premium were significantly lower, an arbitrageur could lock in a risk-free profit by implementing a short nearby/long forward spread, borrowing gold to deliver against the nearby contract and accepting delivery at the expiration of the forward contract. These arbitrage forces will tend to keep the intramarket spreads within a reasonably well-defined band for any given combination of short-term interest rates and ...