2
$\begingroup$

If i have the belief that the futures lead the spot for price discovery, and I am able to forecast the future prices, given this forecast, what would be the best way to back out this number such that it can be used to determine what is the fair value at any given instant?

Would it be easier to just look at the returns of the futures forecast and then just use the spot market to move quotes around. I am mostly executing passive strategies.

For example, the futures LOB looks like this:

Bid Qty | Bid Price | Ask Price | Ask Qty

60   |   1189.5 | 1190.0   |90
4    |   1189.0 | 1190.5   |90
1    |   1188.5 | 1191.0   |90
4    |   1188.0 | 1191.5   |90
12   |   1187.5 | 1192.0   |90

And the spot exchange looked as follows.

Bid Qty | Bid Price | Ask Price | Ask Qty

106  |   1097.5 | 1097.9   |186
405  |   1096.8 | 1098.1   |190
2    |   1096.4 | 1098.7   |100
2    |   1085.3 | 1099.2   |9
15   |   1083.8 | 1099.5   |19

If i thought the fair price for the futures just looking at the order book was $1189.2 and the fair price for spot was 1097

Is there a way I can back out the forecast from the futures to trade the spot and vice versa?

How could i use this value to decide if e futures or spot was trading rich/cheap and how should this value affect how I quote in the spot market as a Market maker?

I personally have had issues with massaging this data.

Sorry if naive question.

Thanks

$\endgroup$

1 Answer 1

3
$\begingroup$

The relationship between S and F is known as "the basis". You can theorize a relationship of the form

$$F=S \exp(c(T-t))$$

or the simpler, approximate $F = S + C (T-t)$. Knowing $F,S$ and $T-t$ (the time to maturity) you can estimate $c$ or $C$ which we might call the "basis per day to maturity". If you constantly estimate it and plot it, you will see that it is mean reverting, with some noise but generally close to a "normal" or "usual" value. You can use the average or smoothed value $\bar{C}$ to see if $S$ seems currently cheap or expensive compared to $F$.

$\endgroup$
3
  • $\begingroup$ Thank you for your answer. I guess by doing this, you are no longer looking at the LOB and microstructure? Instead looking the difference between last print or BBO between the Spot and futures, but assuming that spot and futures wont drift a few ticks away by looking at supply and demand on the bids and offers? $\endgroup$
    – koon93
    Feb 22, 2020 at 16:04
  • $\begingroup$ Yes, I am looking at the bid-ask midpoint for both the spot and the futures, buy you are right that you might want to look at microstructure also. Perhaps we should look at the weighted average of the bids and offers in the book, or some other measure that I don't know about... $\endgroup$
    – nbbo2
    Feb 22, 2020 at 16:16
  • $\begingroup$ You are MVP! Thanks for the answer! $\endgroup$
    – koon93
    Feb 22, 2020 at 16:18

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge that you have read and understand our privacy policy and code of conduct.

Not the answer you're looking for? Browse other questions tagged or ask your own question.