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I recently covered one of the major causes of the 1987 crash and how its modern counterpart is in an even bigger position to tear down markets.
The other major cause of the 1987 crash was something called index arbitrage.
Today, that once-obscure market corner is insanely large, thanks to almost $4 trillion worth of exchange-traded funds (ETFs).
Index arbitrage is simple, and it's happening every second of every trading day. Most people just don't know it.
Even worse is that it doesn't always work. Sometimes it does the exact opposite of what it was built to do, like gravity suddenly levitating everything you think is grounded.
Here's how ETFs and index arbitrage are going to pull the rug out from under the markets…
The Nitty Gritty of Index Arbitrage
In the old days, you might be able to buy gold in New York at $35 an ounce and sell it in London for $36 an ounce. That's all arbitrage is, and it's been around for as long as there have been stock markets.
Back in 1987, index arbitrage mostly referred to aligning the value of the S&P 500 futures contract with the value of the S&P 500 index itself. Traders mathematically determine if the S&P 500 futures contract is being priced in the marketplace at more or less than what the sum of all the stocks in the actual index is worth.
When futures expire, the value of the contract is exactly what the value of the index itself closes at on expiration day. In other words, they converge. But at any given moment, as futures traders and investors buy and sell futures, the value of a futures contract may differ from the value of the underlying index.
If there are a lot more buyers than sellers of futures contracts, like there is on a wave of good economic news, the value of the futures can be more than that of the 500 stocks.
Index arbitrageurs recognize this, buy the all the stocks in the S&P 500, and simultaneously sell a futures contract. That gives them an instant profit from buying something cheap and selling it for a higher price.
It goes the other way too. If futures are cheap, "arbs" will buy futures and sell stocks.
Today, while S&P 500 futures are still popular contracts, traders and investors have other ways to trade the S&P 500. Some ETFs track the index, including the SPDR S&P 500 ETF (NYSE Arca: SPY), iShares Core S&P 500 ETF (NYSE Arca: IVV), and the Vanguard S&P 500 ETF (NYSE Arca: VOO).
ETFs trade on exchanges like stocks, but they act the same way the futures do. Supply and demand, buyers and sellers of the ETFs move their prices, and they may become more or less expensive than the underlying index they're designed to track.
That's when index arbitrageurs go to work, doing the same thing that index arbs did back in 1987 and have been doing all along, buying one instrument and selling another to make a locked-in profit.
It doesn't matter if an ETF is based on an established index like the S&P 500, or the Dow Jones Industrials Average, or some group of stocks an ETF sponsor thinks investors will want to buy in ETF form. ETFs are all indexed products. They're packaged products designed to "track" underlying stocks or commodities, or whatever index they're intended to be a substitute for.
And, yes, index arbitrage is conducted on all ETFs. How much and how often depends on how far an ETF price gets from the value of its underlying stocks.
The ETF Creation and Redemption Cycle
To understand what can happen when index arbitrage goes haywire, you have to understand how ETFs are created and redeemed, and how arbitrage is conducted while ETFs are trading in the open market.
Then you'll see how the players in the ETF creation and arbitrage game are only your friends when things are going their way… and how they will tank the market to save themselves when a crash comes.
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.