Systems Testing, Fair Value and More...

Q. I use eSignal software and follow the DJIA to place bets using Finspreads Wall Street Daily cash index which (apart from their bias) closely matches the real prices on the Dow. I want to be sure the market I'm trading in is the one I'm watching on my real-time charting software.


A: The only way to do that is if your spread betting provider were to stream their prices to eSignal - which they are simply NOT going to do.

eSignal's $INDU symbol is the DJIA itself. It is an index calculated real time from the transactions taking place on the NYSE in the constituent stock. You cannot trade that symbol at all. There are many derivative instruments (i.e. futures, options, tracker stocks etc...) that are based on the index and traded on Exchanges like individual stocks. The spread betting offerings are NOT traded on exchanges. They are their own derivatives. Other than following a real-time quotes graph from the spread betting provider itself (IG have the facility for example) it is a question of following the one(s) that give the most accurate clues to the spread betting derivative movement. The underlying instruments that influence spread betting quotes above all (during market hours anyway) are the current most liquid futures contracts. In the case of the DOW there are at least 2 - the YM #F and the DJ #F - both eSignal symbols. However, you may have to pay the relevant exchange fees before you can use them. Also, they will always be at least a bit higher than $INDU and the spread betting quote. This is a function of what is known as the 'fair value' price of the future which takes account of the costs of holding a contract to maturity. Right now it is over 30 points because the March future is now closed and we're working with the June one (mainly). You need to research futures...etc and could do worse than persusing the educational stuff on the web sites of the various futures exchanges (LIFFE, CBOT...etc)

By the way, for looking at the Dow (or any other US and most European indices) you might (at some point, if not now) like to know that ProRealTime is widely regarded as very similar to eSignal but very much more reliable and versatile, and a fraction of the price. (they also have a free trial available, if you want to have a look at it for yourself).

Q. I'm trying to test a system based on the FTSE but am concerned with the capability of spread bet platforms to get these filled at these exact prices. It seems like it's impossible to backtest this system accurately. For instance when the markets open above or below my long/short entry trigger, or when I try to place orders for the next day after hours and the spread bet company won't allow me to place them because they are quoting higher/lower prices based on their expectations.

A: What exactly is your concern with getting fills? If you place an order on a spreadbet platform then there is no reason to suppose it wouldn't get filled if the price passes through it. Very occasionally the index might gap through it and you get some slippage, but this would hardly be a major concern. Still even more rarely would be days when the futures price triggers/doesn't trigger a trade and the underlying cash market doesn't show the same action, but again this would hardly be a concern.

I actually traded the system one day last week on the DAX and cleared just over £500 on a £10 per point bet on the Capital Spreads platform. I didn't have any fill troubles.

What I think you really should be thinking about is:

  1. Making sure you fully understand how to trade it (what instrument do you trade, how is it operated by the spread betting company, how to set up orders, how to make sure orders are properly cancelled...etc)
  2. Checking the price action on your spread bet platform against your opening data; and
  3. Finding other, probably non correlated markets to trade it on.

A good way to check out 1. and 2. is to trade it, with very low stakes (no more than £1 per point). Spread betting companies don't make their own market in the index. If each spread betting company made their own market they would be vulnerable to arbitrage (i.e. if prices between two spread betting companies differed you would sell one, buy the other and hold till then end of the day when they closed out at the cash market price for a guaranteed profit). They track the futures price, which in turn usually shows where the market is likely to open (although this is not guaranteed).

The fact is you will never achieve a perfect entry with any sustainability which is why you look for an average profit per trade which is high enough to ensure that the slippage hurts but is not disastrous.

You have to remember you can't trade the cash index on any platform anywhere. There is simply no such instrument. The daily cash index quotes, even during daytime hours are derived from the futures price.

Q. Can you provide a little more information on 'fair value' as mentioned previously?

A: One important point you should realise is that the current quoted price of the Future may not correlate to that of the actual Index. There are reasons for this as follows:

  1. The Index future tends have a natural premium built into it called a fair value premium which is above that of the Index you are wishing to trade. This is because there is a natural financial advantage to trading in the future than physically buying the underlying stocks for cash, this is based on the interest advantage of the future. The yield on shares is usually lower than the interest paid on bank deposits. So an investor would, if the futures price were the same as the cash price, get a higher return by buying futures on margin, and then banking the rest of his cash, than he would if he simply used all of his money to buy securities. This premium cancels out this effect. It also takes into account of the fact that someone trading futures receives no dividend. So do not consider this premium as some kind of market prediction that share prices will rise - it is simply a mechanical adjustment to today's share prices. Interest rates are usually higher than any dividend payable on most shares and this is reflected in the price of the Future in question. So the 'Fair Value' is comprised of two items the 'cost of carry' to the expiry of the futures AND the value of all dividends between now and the Futures expiry expressed in index points. i.e a 3p vodafone dividend may be worth about 4 FTSE points.(as Vodafone carries more weight in the FTSE index). This means that the financial spread betting provider's futures price would be spot price plus interest less dividends and then finally adjusted for spread. You can find the theoretical Fair Value on Bloomberg (which is where providers generally start from) Type in FV 'go' on a bloomberg terminal and it will give you all the Fair Values of the major indices. Note that if clients go short then the spread betting firm will sell the real shares (or cfd's) to go short, which means that they then have to 'borrow' them in the market.

  2. Future prices react to news and events much quicker than the underlying Index in question. Therefore the live price of the Index you see on some sites and services may not tie directly with that of the Index Future.

Q. On TV I see quotes like Dow Futures up 18 points and Fair Value up 8 points. What is 'Fair Value' and how is it calculated?

A: 'Fair value' alludes to the appropriate link between the futures and the cash price. Using a complex formula which takes into consideration the present short-term interest rates and the period of time left for a futures contract to expire, one can calculate what the spread between the futures and the cash should be. If the spread is at fair value, there is no assumed gain to owning the futures as opposed to the cash (or vice versa). For professional traders and hedge funds this means that when the spread is at fair value, it makes no financial difference to them whether they buy the futures or the actual stocks constituting the S&P 500 (for instance). In such instances their investment decisions are driven by other factors. However, when the spread drops below (or moves above) its fair value, then either stocks or futures will become more attractive than the other and they will sell one and buy the other.

Q. ETX Capital are quoting the September google stock contract at 4329 - 4349 but the real price of google is about 428.75!?

A: Don't worry too much about this price differential because it can be complex to understand. Basically it's all got to do with what they call the 'cost of carry'. This relates to the fact that a spread better won't have to pay up the full balance to control a certain amount of stock. If you buy £5000 of Tesco using your regular stockbroker he will ask for a cheque for £5000. But if you buy the equivalent of £5000 using a spread bet you might only have to pay say £500, so who pays for the extra £4500, the spread betting firm and he charges interest. It is this figure which accounts for the different price.

The price that ETX Capital quotes is a 16th September Futures price and not the underlying share price. The futures price is calculated as how much it would cost you today to buy the underlying share and hold it until 16th Sep, taking into account the underlying share price, interest rates, cost of carry and any dividends due for the share in that time period. This normally results in the futures price being slightly higher than the underlying market price. This futures price will be roughly the same for all spread-betting companies as if this wasn't the case then arbitrage opportunities would arise.

So just assume the quoted price is correct and concentrate on getting the direction of the stock right! .

Note that usually for US single shares prices are quoted in cents meaning each £1 a point you bet is effectively per cent movement. But since Google is a large stock ETX Capital have created the 10 cent Google contract. So instead of 1 point equalling 1 cent, 10 cents equals 1 point so the contract size is 10 times smaller, thus reducing your exposure.

Q. What are Quarbs?

A: Aka as quasi-arbitrage. This is where companies offer prices that are different but not necessarily far enough apart for an arbitrage as 'Quasi-arbitrages' or 'Quarbs'.

Quarbs are more common than true arbitrages, and spread bookmakers are much less likely to restrict the number of bets on them. Although betting on a Quarb does not guarantee you a profit, we found 140 cases during the last two Premier League seasons. Of these, 86 would have been winning bets and only 50 would have lost. A punter staking a modest £5 per point in each case would have won almost £5,000 over the two years.

Q. Hey fellas, just wanted to tell you that I margin called early yesterday evening I was up 400% my balance in 2 weeks and right now I'm down 0.3%. I broke the number 1 most important rule, don't over leverage your account...

I'm not angry, its just another lesson I learned. I didn't lose my money; I just lost the money I gained over the last 2 weeks so I'm happy. It'll be fun building back up from here, if I can get the same return in the same time I'll think about adding more 'productive' funds.

Happy Trading


A: Tom - It takes heart to take losses and accept them, and to gather energies to be profitable again. I congratulate you for being such a person.

I just want to divert your attention towards a thought, which you might consider changing. The money you made and lost was your money too. You are feeling comfortable about losing the gains, as long as they didn't dent your initial investment. You might consider changing that attitude.

Any gains that you lose is your loss of time and energy that you spent on making it, hence you don't want to take unnecessary losses.

Please don't take my suggestion as criticism. It is just a thought that I wanted to share with you. I wish you all the best and good luck for your trading and life in general.

Q. I have more winners than losers yet I still keep losing overall?

A: You are probably picking profits too quickly and running losing positions for far too long hoping that they will turn round. This is where many traders end up losing more from 1 trade compared to what they would win from 20 winning trades.

Below is an example with a more detailed explanation. I hope this time you will be convinced that a system with poor risk : reward ratio is not necessarily a winning one.
  1. Pot size =£100k
  2. Risk : Reward = 10:1 (which means risking 10 points to make 1 point on every trade). Based on this reasoning we assume each winner trade =1 point and each loser trade =10 point.
  3. System success rate =90% (out of 100 trades, 90 are winners and 10 losers).
  4. Probability of a losing trade = 10/100 = 1/10 (every 10 trades we get a losing trade).
  5. Let us assume first 9 trades are winners. Therefore profit on first 9 trades = 9 points.
  6. 10th trade turns out to be a losing one. Therefore loss on 1 trade =10 points.
  7. Net loss = 10points-9 points = 1 point.
  8. Therefore even with a 90% success rate, you are taking a loss.

Q.: I am keen to get into spread betting and as I have been advised by a few of my friends. But at the moment I am playing with a Capital Spreads DEMO account to learn a little.

The other day I got a little confused, maybe you can help me with this. I decided to buy 50 Nikkei 225. I had done ok so far on the FTSE, so my trading resources were at about £10,800, but soon after I made this bet suddenly my trading resources showed (4,200), which I take meant I was minus £4,200. I cannot understand this figure. Surely if I bet £50 per point even if it moved 50 point that would only be 50x50 = £2,500 so what was going on, I'm lost?

A: Sounds about right. On Capital Spreads the 'margin factor' for the Nikkei is 300x - so in other words you need 300x your bet in your account as 'trading resources', or in your case for a £50 bet - £15k. Capital have in fact charged you £15k, and this means they run a 300x margin factor for the Nikkei. The margin factor is all about expected volatility - think about it: suppose the Nikkei is about 16,300 at the moment.. The 50 point move you talk about would be less than a 0.3% move in the index - easily within the range of an hours' trading, let alone a day. They just want to make sure you have enough money up front to be able to settle at least a day or so move going against you. Or put another way, £50/point on a 16,300 level index is equivalent to an underlying position of £815,000. £815,000 is the notional value. Putting it like that, requiring you to put up £15k of your own money isn't too unreasonable...!

This requirement is irrespective of where you set your stop. Imagine if Junichiro Koizumi was assassinated while the Nikkei was closed. Your 50 point stop would be "pounded like a rented gerbil" when the market opened. The margin requirement goes some way to protect against this. With a real account I imagine you would not have been allowed to place a bet that size without the necessary funds to cover the margin.

 ...Continues here - Spread Betting versus CFDs

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