Many investors in equity index products use the official closing index level as their benchmark for trading. But when trading futures, how can you execute against the closing index price?
Basis Trade at Index Close (BTIC) solves this problem by allowing you to trade futures at a fixed spread to the closing underlying index level. This works when a buyer and seller agree to trade futures contracts, but instead of agreeing to a specific price, they agree to a spread, or basis, to be added to that day’s closing index level to determine the futures price. This basis is agreed upon before the day’s index level is known. The value of the basis depends on the all-in financing rate, dividends and the time left to contract maturity. The value can be either negative or positive. Once the official closing index level is published, the actual futures are transacted at a price equal to the closing index level plus the agreed-upon spread.
A fund manager benchmarked to the Russell 1000 Index receives an inflow of $20 million to be put to work at that night’s closing index level. At the current index level of 1,176.10, she calculates that the fair spread between the Russell 1000 futures and the cash index is -340. She submits a bid to buy 170 Russell 1000 futures at that spread versus the evenings closing index level.
At the same time, a trader on the equity finance desk of a large investment bank concludes he could save money by replacing his short physical stock position in the Russell 1000 constituents with futures. He calculates that he needs to sell those futures at a basis of -340 or higher. He sees the fund manager’s bid and hits it.
The trade is executed. Having sold the futures, the equity finance desk then enters a portfolio trade to buy a $20 million index-replicating stock basket at the closing market price to reduce his short stock position as planned.
The BTIC trade is complete.
Shortly after 4 p.m. Eastern Time (ET) the official Russell 1000 index close of 1,177.03 is published. The trade is now settled. The fund manager buys 170 Russell 1000 futures at a price of “eleven seventy-three, spot, sixty-three” , which is a $3.40 negative basis to the closing index level, and the equity finance trader sells them at the same price.
A wide range of market participants use BTIC for an off-exchange block trade or through the order book where available. We have seen how index fund managers can use BTIC and also how it allows equity finance, index arbitrage and stock loan traders to optimize their holdings between futures and physical stock. Other participants include equity swap traders who use BTIC when hedging market-on-close trade exposures and index option traders who use BTIC to take advantage of the surge in volume at the cash close to adjust futures delta hedges with minimal impact. The BTIC order book is open 23-hours-a-day, allowing real-time price discovery in the futures basis as investors around the globe submit orders against the next index close.
For more information, go to cmegroup.com/BTIC.