Noel
Campbell 		Over the past few weeks I have put the topic of ISF aside. This week I have received several calls relating to how the price of an ISF relates to the price of the underlying stock. We advocate that a trader follows the chart of the stock to identify a trade and calculate the entry and exit points. The orders given to the broker are based on prices associated with the underlying stock.

So you may be telling your broker to buy ISF when the underlying stock trades at $10.00 for example. However, the fill price you receive on the ISF market may be quite different to $10.00. As a refresher, if a futures contract is trading below the physical, the contract is trading at a discount. If the futures are above the physical, the contract is trading at a premium.

The size of this discount or premium on the ISF market may be quite considerable. There are of course underlying reasons for this fact. If a stock is due to pay dividends before a contract expires the ISF for that stock will be trading at a discount. This is due to the fact that the market makers are factoring in a fall in the share price once the stock goes ex-dividend. The reason why an ISF will be at a premium to the stock price is that the market maker is factoring a ‘cost of carry’ into the price. A market maker may buy or sell the physical stock to hedge their exposure in taking an order from a trader for an ISF. This of course will incur an interest charge as they lose the benefits of using those funds, while they need to remain hedged.

Returning the discount situation again, once a stock has gone ex-dividend, the ISF price will jump back up to a premium, as the market maker now only needs to consider the ‘cost of carry’.

This recently occurred on the January 2004 contract for WBC futures. Chart 1 is the recent daily market action for WBC with a line chart of January 2004 futures overlaid. In circle 1 you can see how the futures were trading at a discount to the stock price. However in circle 2 (after the stock went ex-dividend) you can see how the futures price jumped up to a premium. This is beneficial if you are long the stock, but a problem if you are short.

Chart 1

click image for more detail

Now that WBC has gone ex-dividend the January contract will be safe to trade in terms of the risk associated with this switch from discount to premium. It goes to show how important it is to the ISF trader to know the approximate time that a stock goes ex-dividend. If you are in a short trade just prior to a stock going ex-dividend you have to show caution. Once the stock has gone ex-dividend the associated risk has passed. The January and April contracts for WBC should be safe to trade short, as they both expire before the next WBC dividend payments. This is only a brief look at this subject but gives us a good start.

Until next week......

Noel Campbell