By Fernando Gonzalez of EvolutionTrading.NET*
Posted: Oct 23, 2009
This article is written to benefit the individual, independent trader.
While many will agree that the Dow Jones Industrial Average is the most popular equity market measure, it's the S&P500 Index that sits at the epicenter of, not just the U.S., but the global equity markets' measures. In the world of professional trading, the S&P500 is the primary barometer for market performance, environment and conditions absolutely crucial to decision-making in nearly all management of risks exposed to equity markets. It is used by a wide range of market participants from large mutual funds, to the media, to the independent equity day trader.
Over time, the existence of this index has provided for a multitude of financial instruments designed to use this barometer as a direct underlying measure of risk and reward. Among the many instruments used by investors and traders alike, two have emerged as the most versatile – the exchange-traded fund known as the SPY and the S&P500 E-mini futures contract. Both instruments are extremely liquid and have market participants from a wide range of sources. Everyday, and at current market levels, approximately $20B (~200m shares) is exposed in the SPY, and approximately $100B (~2 million contracts) is exposed through the S&P500 E-mini futures.
The answer to whether one should trade the S&P500 E-mini futures or the SPY is always the subject of great debate. As mentioned earlier, this article is written for the independent trader, and although we acknowledge that the issue is generally debatable either way, conducting a closer examination and breaking down different objectives, styles, experience levels and methodology should make the decision process a lot easier.
With this article, I hope to guide independent traders in deciding whether the SPY or S&P500 E-mini is the proper instrument to trade the S&P500, and the decision isn't really all that difficult to make. I just have to outline some pertinent variables and provide information on some of the pros and cons of each so that you can make a proper decision.
What are some of these variables?
- Commission costs
- Charting, data analysis and formulation
- Execution
- Minimum risk and capitalization
Let's examine these variables.
Commission Costs
Take a tour on the web and learn the commission cost differences between trading stocks (the commission structure used for trading the SPY) and trading futures. It won't take long to recognize that the commission costs associated with trading futures are lower than those charged for taking equivalent risk exposure or position size trading straight equities.
Risk exposure being equal, the E-mini futures easily win over the SPY here. The cost differential is much more significant for intraday traders than it would otherwise be for swing traders (by our definition, a swing trade is any trade that is taken through one or more closing bells).
High-frequency traders should estimate the number of trades they make per day / week / month to get a realistic number on exactly how much of a dollar difference commissions would amount to when trading the SPY versus the E-mini – this amount can be very significant.
Low-frequency traders, however, (swing traders with only a few trades per week or less) will find that the difference between the SPY and E-mini commissions is a negligible factor in comparison to the range of uncertainty of the S&P500 in swing-term time frames – size of exposure will play so much more of a significant role for these participants.
Later on in the article, however, as we look at the combination of variables, the advantage of the E-mini commissions for high frequency trading over trading the SPY will become apparent – stay tuned.
Charting, Data Analysis and Formulation
Some say that the S&P500 E-mini futures contract is the near-perfect trading instrument, having almost all the favorable characteristics any trader would want. Although I can't agree 100 percent, as I shall demonstrate later in this article, we can say that this is true in many aspects. Among the many advantages of the E-mini is the awesome order in which the contract is exchanged, particularly on the battle lines, at the bid / ask level and in the way in which Time and Sales is ultimately tracked for charting and analysis.
Although data accuracy can vary from one provider to another, as a general rule, and on an intraday basis, the SPY is no match for the quality of E-mini trading. This is because the SPY, despite its tremendous daily liquidity, is susceptible to the very same "occasionally-miserable" characteristics that individual equities exhibit: Late or bad ticks and millisecond liquidity vacuums (particularly in fast markets and almost daily at the open and closing ranges) that throw off the balance of the data. In English, the E-mini is comparably much more orderly than individual stocks, and the SPY, as an "individual stock" is no exception here.
In the case of data accuracy, however, total victory does not belong to the E-mini. As specified earlier, the SPY is no match for the E-mini on an intraday basis. The tide begins to turn in favor of the SPY, however, when longer time frames come into play. Because the E-mini futures have a limited lifespan, their trading incorporates the element of time decay. Because pressures of time decay affect price, charts over longer time frames that extend beyond intraday are affected. Over time, support and resistance (S & R) levels, which are a true reflection of turns in liquidity pressure, are more accurate in the SPY than they are in the E-mini futures.
Formulations, such as the continuous S&P500 futures contract charts, to account, "adjust" or "correct" for time decay and the cycles of expiration in the accuracy of the E-mini futures chart have been attempted, but it is clear that these are only "correct" in mathematical theory. With the exception of the occasional slight difference in dividend adjustment for the SPY, the SPY, over longer time frames, is a much more reliable chart than the E-mini. The SPY can react to S & R and day-to-day liquidity vacuums (gaps) even years after the fact; whereas, the E-mini marks would have long been forgotten.
In a nutshell, for charting, data accuracy and formulation of technical strategy, the E-minis win on the smaller, sub-10-day time frames while the SPY dominates the longer time frames.
Execution
Comparing execution between the SPY and the E-minis is a very tricky subject. It largely depends on your trading style, objective and experience, as well as market conditions: Intraday, swing, master trader versus one with little or no experience, trend-following versus arbitrage, manual versus automated, fast versus slow markets… so many factors to account for that it can be very confusing.
A "master" in each market might develop a plausible argument for whether one is better than the other, backed up by consistent profits, while some "rookies" might spend all day long debating over something that's way too complex for their experience level, backed up by nothing but losses. I'll do my best to weigh the pros and cons, though, and in so doing, hope that the "bottom line" on "which is better" will not be all that difficult to develop.
Just as in any market, the minimum tick value plays a very important role in execution, particularly in high-frequency trading. The SPY, just like any other stock, has a minimum tick value of 1 penny (and for the sake of our sanity, we will exclude the fact that it is possible to execute, through some ECNs, in fractions of a penny). The E-mini, on the other hand, has a minimum tick of 0.25 point. Because of the divisors and how each is structured, this means that the SPY will have more tick movements and executions than the E-mini.
To be more exact, the SPY exhibits, on average, 2.5 times more tick movements than the E-mini. Any market that has more tick movements than its equivalent will be susceptible to slippage. Therefore, the SPY will, naturally, and by intrinsic design, exhibit much more slippage than the E-mini.
It will be easy for most anyone to associate "slippage" negatively in relationship to trading, and anyone could understand why. However, any profitable day trader will know that slippage is an opportunity that can cut both ways. It can be a good or bad thing, depending on whether you are on the giving or receiving end of it.
And, whether you are on the giving or receiving end of slippage depends largely on momentum and the direction of your order: A master of momentum, whether a profitable individual trader or some profitable automated system, will almost consistently outperform lesser experienced participants. This means that, even though the SPY has more slippage, this can actually be viewed as a positive, and perhaps even a winning, distinction over trading the E-mini.
To understand comparative execution between the SPY and the E-mini, let's examine, using the illustration shown below, the typical execution level and volume distribution on the SPY versus the S&P E-mini futures.
Based on the information in the previous table and with the ability to take advantage of positive slippage, experienced, high-frequency manual traders and sophisticated automatic trading systems will benefit on the SPY versus the E-mini. The difference between the SPY and the E-mini for less experienced, lower-frequency swing traders or in the case of less sophisticated execution is negligible due to other overwhelming factors inherent to this group that can affect performance.
Up to this point, we have seen the following with respect to three of the four factors listed at the beginning of this article:
Commission Costs: The E-mini is favorable for high-frequency intraday traders; producing generally negligible results otherwise.
Charting, Data Analysis and Formulation: The E-mini is favorable for intraday, sub-10-day charting / analysis; the SPY is favorable for longer time frames.
Execution: The SPY is favorable for more experienced high-frequency, manual traders and sophisticated automatic intraday systems; producing generally negligible results otherwise.
For high-frequency and experienced traders, the choice between the E-mini and the SPY will depend on style, methodology and level of frequency and factoring in the point at which one variable trumps another. Surely, for profitable methods, the nit-picking is worth it in most cases.
However, we have one more variable to discuss, and, for entry-level, low-capitalization traders, it means absolutely everything, trumping just about all other variables.
Minimum Risk and Capitalization
Let's begin by discussing the basic risks in each Instrument. It is a given that both Instruments are designed to track the movement of the S&P500 Index. As a general rule, the comparative price change for each is accounted for as follows:
1 S&P500 Index point movement = a 1-point movement in the S&P500 E-mini = a 1/10-point ($0.10) movement in the SPY.
While the comparison of price change between the index and the E-mini is generally 1/1, the equivalent movement in the SPY would be 1/10.
The E-mini contract, however, is structured so that: 1 S&P500 E-mini point = $50 / contract.
When we compare the SPY to the S&P500 E-mini, this, therefore, means that, on a per-contract (the E-mini) and per-share (SPY) basis, risks compare as follows:
1 S&P500 E-mini contract is "generally equivalent" in risk to 500 shares of the SPY.
We say "generally equivalent" because many variables can slightly affect the balance of risk between the two. However, the comparative risks between the size we can trade on the S&P E-mini versus on the SPY are crucial to consider, and I shall explain in a moment.
Let's talk about capitalization first: How much does it cost to open an E-mini futures trading account versus a SPY trading account? While the minimum balance required to participate in either market (futures or equities) is generally the same (you can open an account in either for $10,000 or less), we have to consider the SEC's "Pattern Day-Trader Rule", which requires a $25,000 minimum account balance for frequent trading of equities. So, if a trader sets out to actively trade the SPY, he or she will have to capitalize $25,000, plus the additional amount needed to serve as padding to prevent the account from falling below the minimum.
At the entry level, trading the minimum for "actively" trading the E-mini futures versus the SPY is a very easy decision: Why should anyone put up $25k to trade the SPY when he or she can put up $10k or even less to trade futures? It seems pretty straightforward…but it's not.
I believe, and anyone would agree, that it's consistent practice that paves the way to success as a trader. Trading the SPY provides the opportunity for entry-level traders to practice more with less risk, thereby maximizing the opportunity to succeed. With the SPY, the trader has the ability to modulate and "break up" the risk of an E-mini contract (equivalent to 500 SPY shares) by trading in increments of round lots (100 shares) and mitigating 5 times the risks off the table.
I'm quite sure anyone would agree that an entry-level trader has greater risk than reward, right? The question should, therefore, not be, "Why should anyone put up the $25k to trade the SPY?" Rather, it should be, "Why should we assume more risk to trade the E-mini at a stage when we will be learning the very same lessons by trading either one?" It's a matter of survival.
The SPY is an awesome learning ground for the entry-level trader. Even if the trader attempts to trade the E-mini with capitalization of $25k or more, this does not change the fact that, because this trader is a beginner, his or her ability to modulate the risks down to significantly lower levels still makes the SPY the more logical option – regardless of execution, commission cost or commonly available methodology.
In fact, the advantages of being able to "break up" E-mini contract exposure through the SPY can apply to non-entry-level traders – any profitable trader playing for less than $500k per year will know that there can be tremendous advantages to the flexibility of varying position size and scaling through the SPY.
Perhaps, one day, the CME will offer an "E-mini-mini" (eMicro Futures?) that would match a round lot of the SPY, and for the sake of entry-level participants and allowing them the best chance to succeed, I wish the CME did just that. While the E-mini futures are otherwise awesome, they are no entry-level instrument.
In the world of entry-level trading, it gets even better for the SPY: The ability to trade at lower-risk exposure levels also provides for lower commission costs based on per-share commission schedules. Some brokers will offer as low as 30 cents per 100 shares traded although a $1 minimum is more common. This drastically takes the cost of actively trading the S&P down – up to 5 times lower commissions over common charges for the E-mini. In a world where even entry-level traders can easily rack up thousands of dollars in commission costs, the decision to go with the SPY is too easy.
In that popular show, "Who Wants to Be a Millionaire?", the contestant is allowed three lifelines. To use it as an analogy in this discussion, the SPY provides five times more lifelines to get to the million bucks. I can't imagine a better analogy. Let's boil it down to a simple thought: Two contestants on the show compete for the prize. One has three lifelines; the other has 15. And, the winner is…?
If you want to trade the S&P, or even one day "graduate" to the E-mini itself (and beyond), start off trading round lots of the SPY, or even a few round lots, so you can have the luxury of scaling your orders. Find a good broker who will offer competitive commission rates. If you want the best chances to succeed, find a way to get capitalized, practice until your eyeballs hurt, and of course, a good mentor can make a significant difference as well. Good luck!
*Reprinted (and modified) with permission from Fernando Gonzalez, the founder of EvolutionTrading.NET, a premier stock market school in Laguna Hills, CA
