Price Action Trading Strategies That You Need to Know
Trading guides, webinars and stories
Trading guides, webinars and stories
How often have you come across the expression “trade the market”? I bet you’ve heard it at least once, if not more. Aside from a widely successful trading strategy, oftentimes, “trade the market” means investing in the leading global index – S&P 500. There are two ways to invest in the S&P 500 that have proven to be the most popular – through an ETF or an S&P 500 E-mini futures contracts. In the following guide, we will deep-dive into the latter.
From leading international market makers and investment banks, through boutique algorithmic trading companies, to individual traders – all market participants invest in the S&P 500 E-mini futures. To learn what makes the instrument so popular among all market participants and find out the most important things to consider if you decide to invest in it, you can start with the following guide.
The S&P 500 is an American stock market index that was designed way back in 1923. Initially, it was named “The Composite Index” and contained 90 companies. However, throughout the years, the index coverage expanded and, today, it includes the shares of the 500 largest companies by market cap, listed on NASDAQ and the NYSE. Today, the broad-based, capitalization-weighted index, is considered a vital indicator of the stock market’s health.
At first, when the index was composed of fewer companies, and their shares were cheaper, investors were able to purchase it directly. However, over time, as the number of constituents rose, and their shares became more expensive, investing directly started to become very hard.
This was the moment when ETFs and futures contracts came to the rescue. Today, investors can “buy” the whole market by simply purchasing an ETF or a futures contract directly from their broker-dealer. Nowadays, the S&P 500 is one of the most popular investable instruments worldwide. If we take a look at its historical performance, we will find out that this is no surprise.
You will struggle to find another instrument that delivers continuously and in such scale. The most important thing is that the performance of the index is increasing over time. If we take a look at its returns for the last ten years, the figures are even more convincing. The returns for the period January 2nd, 2009 – July 1st, 2019, are a staggering 258.24%.
Furthermore, analyses point out that the market beats 95% of active money managers which you pay to manage your investments.
This, alongside the benefits of diversification that buying the whole index provides, have lead to an increased interest in the instrument.
To get a better understanding of why the S&P 500 is such a popular instrument among leading investors, let’s see what the Oracle of Omaha has to say. Because when Warren Buffet speaks, we listen.
“I would buy the S&P 500 in a second.” –
Buffet also admits that, over time, it had been hard even for him to beat the S&P 500, while his mentors Todd Combs and Ted Weschler, have each under-performed the index during the past few years.
As you are now fully aware of the S&P 500’s characteristics, let’s proceed with understanding one of the most popular tools for investing in the world’s leading index – the E-Mini futures contracts.
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The E-mini S&P 500 is an electronically-traded futures contract, launched and traded on the Chicago Mercantile Exchange (CME). The contract represents 20% of the value of the standard S&P 500 futures contract. The instrument is often referred to simply as “E-mini”, which is not entirely accurate. There are many other E-mini contracts on indexes such as the Nasdaq 100, S&P MidCap 400 Russell 2000, as well as on commodities and currencies. However, over time, people started to refer to the S&P 500 E-mini contract as “E-mini”. The instrument became so popular that it effectively turned into a byword for the world of futures trading.
The S&P 500 E-mini Contract has come a long way to become the most popular futures contract globally. The E-mini (ticker: ES) is considered one of the most cost-effective ways for investors to gain market exposure to the world’s biggest companies by market cap.
The E-mini was introduced in 1997 with the main reason of lowering the barrier to trading at a time when the value/cost of the existing S&P 500 contract had started to rise exponentially. Suddenly, the index became too expensive for retail traders, which was when the E-mini came to the rescue. It quickly established itself as the most popular index futures contract on a global scale.
Although the S&P 500 E-mini was designed to bring flexibility and affordability to the table, today it is a preferred investment even for the biggest hedge funds. The average daily implied trading volume for E-mini futures contracts is estimated at between $100 and $200 billion. These figures exceed the combined traded volume in US dollars of all 500 underlying stocks.
When it comes to the technical parameters of the contract, it is worth noting that the daily settlement prices are the same as those of the regular (full-sized) contract. This means that 5 E-mini contracts equal the financial value of one full-sized contract. In terms of functionality, the E-mini replicates full-sized contracts in full. Both instruments are used for hedging and speculation with the only difference that the E-mini is used by all types of traders, due to its affordability.
|Contract size||$50 x S&P 500 Index|
|Minimum Tick||0.25 Index points|
|Dollar Value of One Tick||$12.50 U.S. Dollars|
|Trading hours||Sunday – Friday 5:00 p.m. – 4:00 p.m. CT with a trading halt from 3:15 p.m. – 3:30 p.m. CT; Daily Maintenance period Monday – Thursday 4:00 p.m. – 5:00 p.m.|
|Contract Months||Nearest five months in the quarterly cycle (March, June, September, December)|
|Options Available||Quarterly, Monthly, Weekly (Monday, Wednesday, Friday)|
Data source: CME
Although one of the most traded instruments worldwide, the S&P 500 E-mini (ES) has some tricky points that many investors fail to acknowledge. So let’s get into details and find out the most important characteristics, both positive and negative, of the instrument to help you make a rational and informed decision:
The “E” in the instrument’s name comes from “electronic” and emphasizes the fact that the contract can be traded digitally and not the “old school” way in the trading pits. A huge advantage of electronic trading is higher and constant liquidity. Traders that buy and sell can do that more quickly, in a matter of seconds (or even milli- and micro-seconds when it comes to high-frequency traders) which ensures constant trading activity.The futures contract is so widely popular that periods of low daily trading volumes are sporadic. This is partly because the instrument is a preferred choice for day traders and speculators who place and execute numerous trades per day.
However, since 2018, the daily trading volume of the E-mini S&P 500 futures is shrinking. The reason for that can be found in the volatility levels. Usually, when markets are more volatile (which was the case throughout 2018), the liquidity levels drop. On the other hand – when markets get calmer, liquidity gets back to normal. According to JP Morgan, December 2018 was a period marked by a massive stock market selloff that affected the S&P 500 E-mini futures and lowered its liquidity to levels unseen since the 2008 financial crisis. Moreover, once liquidity goes down, price swings become more often.
That is why it is essential to keep an eye on liquidity and volatility levels to be able to predict potential market turbulence accurately.
Since the E-mini is one of the most popular investable instruments worldwide, it is also a preferred environment for market manipulating traders or speculators. The most notable example is the Flash Crash from 2010 when a single seller sold more than 75 000 E-mini contracts.The Flash Crash was caused by Navinder Sarao, a sole trader, who instructed his algorithms to place a large quantity of E-mini S&P 500 contracts with the intention to cancel them right before execution – a process, also known as “spoofing”. However, the essence of the problem is not the volume. It is rooted in the fact that all contracts were dumped over a very short period.
This caused temporary market chaos and artificial selling interest, which lead to the crash of the instrument’s price. The idea behind this was for Sarao to buy the E-mini at the cheaper rate afterwards once he had already driven their price down. Reports pointed out that the trader replaced or modified his bets more than 19 000 times before cancelling them. Although the Flash Crash lasted for just 15 minutes, it lead to a massive 9% drop in the prices of leading indices. Estimations point out that during the Flash Crash, more than $1 trillion in market value disappeared.
There are other flash crashes associated with the E-mini S&P 500 futures as well. On December 7th, 2016, a group of traders bought approximately 16 000 contracts at the same nanosecond. The value of the trade was estimated at $1.8 billion. The result of the massive purchase was a bullish price movement that helped some traders realize profits by selling at higher prices.
Due to the high liquidity and relatively low volatility, the E-mini S&P 500 paves the way for the application and execution of multiple types of trading strategies – from capturing price momentum, through long-term holding, to trend following and swing trading. When compared to many other markets, there are no particular restrictions or rules for shorting E-mini S&P 500 futures. To short-sell stocks, for example, you will need a special account with individual (increased) requirements. Some shares are very limited or cannot be shorted at all. In dynamic market conditions like those of today, this significantly reduces the trading flexibility.
Aside from that, stock traders who execute 4 or more day trades in the period of 5 business days (provided that the number of day trades exceeds the client’s total trading activity by 6% for the same period) are considered Pattern Day Traders by the SEC. If you are classified as a Pattern Day Trader, you are required to maintain a minimum of $25 000 of capital in your account all the time and not fall below this level. On the other hand, futures traders can start with just 10% of that sum.
Aside from that, the S&P 500 E-mini market allows for trading on leverage, which is not possible when trading the majority of stocks. Those stocks that allow for such an opportunity require at least 50% margin to take a position. FX trading firms in the US, for example, are allowed to offer no more than 50:1 leverage ratio on leading currency pairs and 20:1 on secondary pairs.
All this makes the S&P 500 E-mini an excellent opportunity for sophisticated traders who want to exploit short-lived profit opportunities.
There are numerous markets out there, yet many people choose to become full-time E-mini S&P 500 (ES) day traders. But why is it so compelling? It is clear that if newbies or even professionals who have been involved in equities, fixed-income, and FX trading are choosing the futures market, there must be some significant reason.There are many reasons in fact, however what beginners and professional traders find essential is the fact that the E-mini is traded on the CME – a regulated central exchange that records all trades in real-time and issues sales reports.
The trades on the exchange are public and are executed on a first-come-first-served basis. They follow the CFTC (Commodity Futures Trading Commission), NFA (National Futures Association), and CME’s clearing rules and guarantee that all traders have access to the same Level II bid-ask spreads. All this makes the trading process much more transparent and secure.
However, there are some other reasons that intrigue beginner and professional traders and make them switch to day trading S&P 500 E-mini futures. Here are some of them:
Those who are making their first steps into the S&P 500 E-mini futures market choose it because it is considered one of the easier instruments to start with. The reason for that is, because for the most part all you need to trade E-mini contracts are a few charts. Trading this instrument is highly technical and does not require considering too many factors, which is why beginners can quickly learn the basics.
Another reason is that it is relatively affordable to open an account. You can do that with as little as $2 500. Traders can buy and sell without any restrictions.
The third and very crucial reason is that even a simple “buy and hold” strategy has proven to be more effective and better-performing in the long-term, than many professional active money managers.
Experienced day traders prefer the E-mini market due to its higher intraday volatility. The dynamic price fluctuations result in multiple profit opportunities on a daily basis that can be exploited and capitalized on. Due to that, many day traders are involved in no more than an hour or two of frequent trading activity at the start of each trading session, which is enough for them to be consistently profitable in the long term.
Experienced day traders also prefer S&P 500 E-mini contracts (ES) due to the possibility of trading on leverage. For example – a trader with just $500 of capital can trade up to $75 000 worth of ES contracts at once, which accounts for a leverage of 150:1. This provides traders with great flexibility, which cannot be matched in many of the other markets.
To understand the main factors that affect the price of the E-mini, it is worth starting from the allocation of the constituents. The S&P 500 consists of companies in a variety of sectors with the following approximate allocation:
Corporate announcements, industry trends, or third-party intervention (like lawsuits or Facebook’s industry-defining $5b fine) are the main movers of the price of separate stocks, thus the whole index. However, aside from these distinct factors, there are some other factors that you should be aware of if you want to be a successful E-mini trader:
The Federal Reserve (FED) is one of the major factors that influence the direction of the market. By maneuvering between interest rates, the regulator can affect the actions of market participants, and thus impact the price of the instruments. That is why traders usually anticipate the FED’s statements on their plans for interest rate hikes. For example, when the FED issues a statement that it will remain passive and won’t increase the interest rates, the market is instantaneously affected. Investors usually assume that it is a good moment to abandon fixed income instruments and invest in real estates and stocks, in search of higher returns. This shift usually results in a massive boost for the S&P 500 index.
On the other hand – if the FED reveals plans for interest rate hikes, then traders tailor their investment strategies accordingly and usually focus on increasing the percentage allocation of fixed-income instruments in their portfolios. That way, they are capable of reducing risk while at the same time ensuring higher returns.
An essential factor for predicting the direction of the S&P 500 index (and the E-mini contracts respectively) is the state of the global economy and international affairs. Trade wars, military conflicts, economic sanctions – events like these usually affect the market in a negative way, as many of the S&P 500 constituents are global companies with wide exposure and operations spread all across the world. The tech companies, included in the index, usually rely on China for the production of key components of their products. Energy businesses, on the other hand, may rely on companies from the Gulf, Africa or the Middle East for their imports of petroleum. Consumer oriented companies like Starbucks, for example, rely on Ethiopia, Kenya and other African countries for the imports of coffee beans. Should there be a global conflict or instabilities within the key markets that the S&P 500’s constituents rely on to run their operations, the index is usually the first one to reflect that.
Often times, plans for economic restrictions or trade wars are speculated on as a part of political maneuvers. However, although these political moves are most of the time speculations that may never materialize, markets are still often affected. This game of back-and-forth is a very tricky one, as the market usually reacts to intentions and predictions rather than facts. That is why, when you trade make sure to be cautious if there is too much optimism. Bear in mind that even the smallest setback in trade talks or international political dialogues can result in a market drop. It is essential always to paint a realistic picture and even underestimate the possible positive outcome of the situation, rather than the opposite.
One of the key examples of market-moving events are usually the presidential elections in the USA. The case is often the same – one of the candidates is a fan of a more liberal market policy, while the other is campaigning for stricter regulations. During debate season, the S&P 500 usually reacts to every bit of news from both political camps. The index starts to experience more frequent price fluctuations, which makes it hard for traders to navigate the market and tailor their trades accordingly. The reason is that markets do not like uncertainty, which is precisely what presidential debates are all about.
However, when campaign projections start to become clearer, the index starts to form more steady patterns. If the candidate, rooting for tighter regulation, is leading, the S&P 500 gets bearish. If the one rooting for loose regulation is gaining an edge, the S&P 500 responds positively and gets bullish.
The E-mini is, without a doubt the most popular futures contract worldwide. This means that there is both more liquidity and more competition for the best profit opportunities. However, over time, the instrument has established itself as a perfect investable universe for beginners and advanced traders.
As of now, it is one of the most preferred ways to capitalize on positive market trends by riding the upward trend of the market cycle. However, you should be aware that, in turbulent market periods the S&P 500 is one of the first instruments to react. This means that if you decide to trade the futures on the world’s leading index, you should be very cautious and keep track of multiple factors, such as the FED’s policy, global economic trends international relations and political instabilities as well as a keen eye on the developments and key moving factors in a variety of industries. If you’re ready to take on the S&P 500, sign up for The Gauntlet Mini™ here and take your first step to becoming a professional trader.