The Noise Is The Signal

[Chris McConnel]

The Swing Shift
A Fresh Look at the Equity-Index Connection
By Alan Farley
Special to RealMoney.com

7/6/2004 11:30 AM EDT
URL: http://www.thestreet.com/p/rmoney/theswingshift/10169339.html

Trading Strategies
• A big crowd follows the index futures.
• That creates intermarket correlations.
• Don't worry about them for long-term holdings.

For years, I've cautioned traders to keep an eye on the index futures before making important decisions about their equity trades. Sometimes I think my comments on this subject raise more confusion than clarification, so let's take a fresh look at the equity-index connection and examine the dynamics of this relationship.

The advent of the Globex electronic index futures contract parallels an explosion in program trading and high-end arbitrage techniques. These plays are rigged to exploit short-term inefficiencies between stock and index future prices. As a result, wiggles in the index futures seem to correlate with related wiggles in the equity markets. Traders benefit when they keep one eye on this index swing and use it to filter their equity positioning.

Moving in Lockstep

Keying off the index futures is a self-fulfilling prophecy in today's markets. A massive crowd now follows the index futures and reacts to every intraday swing. This herd behavior generates all kinds of intermarket correlations that barely existed a decade ago, before the advent of the electronic contracts.

In my estimation, the index futures now account for 60% to 70% of all movement in individual equities. But that doesn't mean the contracts induce a parrot-like state that forces equities to print out identical patterns. Rather, this lockstep connection refers to buying or selling pressure that's driven by unique supply-and-demand calculations.

We've all taken equity positions in which sudden movement in the index futures destroys a perfectly good trade in minutes. But this broad influence doesn't replace individual equity patterns most of the time. Simply stated, there's usually buying pressure in stocks when there's buying pressure in the index futures, and vice versa when there's selling pressure.

For stocks, 52-week, daily and intraday highs tend to dry up when the index futures are selling off. Conversely, 52-week, daily and intraday lows start to dry up when the index futures are rallying. Equity volume and the Tick reading also spike significantly when the index futures jump up or down just a few points.

A good share of this intense interconnection arises from program trading. But hundreds of chart patterns unrelated to the S&P 500 or Nasdaq 100 indices show similar price action. However, each relationship is different and triggers a set of price bars unique to the specific equity instrument.

How can equities hold support or resistance levels with the constant pull of the index futures? The answer is that they don't hold these levels as well as they did in the past. I've written about pattern failure for years, placing most of the blame on big money traders using their considerable resources to break through major price levels. But the index futures may be the real culprits. It's obvious that small traders are more willing these days to sell through support, or buy through resistance, because of related movement on the futures charts.

It makes sense to align stock trades with index futures movement, but there are important exceptions that affect this strategy. First, energy and metal stocks often go their own way or trade against the indices. In fact, these have kept many trading accounts intact this year while the broad market chopped around. Of course, these stocks react to a different set of external conditions, such as global supply and politics.

Hot Stocks

Second, there are "plays of the day" that attract so much volume that they'll overcome adverse index movement. This is a tough one to call, because these stocks can also fall apart and join the broader market with little warning. The best advice is to trade them, but to stay defensive and take smaller profits when the index futures are moving in the opposite direction.

Alternatively, hot plays will run even hotter when traders can't find other positions due to adverse index futures movement. These sessions tend to generate a pool of trader liquidity searching for opportunity. In turn, this allows momentum in a few hot stocks to run wild.

Keep in mind that the index futures affect shorter-term time frames. They rarely matter when traders are taking longer-term equity positions. In fact, it's wrong to avoid these positions because of adverse index swings. For example, don't get caught up in the intraday futures when you're making a swing trade with a one- to three-week horizon,

At this point, you may think the best path is to abandon equities and just trade the index futures or exchange-traded funds directly. But these complex instruments require a completely different mind-set than equities. Sure, it's great to play the futures markets, but you'll still need real strategies with manageable reward/risk.

The index futures act according to an internal reality that often defies logic. For example, try to trade a simple triangle or double-top pattern in these markets, and you'll get crushed. Remember that your competition in the stock market includes less-informed retail traders, as well as patient investors. In the futures markets, your competition will be professional traders who have already survived every mistake you're about to make.