Thanks for posting this Don. I get so many people asking me to spell out the basics of opening orders and I can't find the old old threads that talk about the specifics. So I'll add some of my own info here and then bookmark it for future reference.
"Where do you find fair value, and what is it"?
http://www.programtrading.com/buysell.htm
or
http://www.indexarb.com/
The numbers aren't exactly the same, and you can use either one, just try to be consistent in which one you use.
Fair value represents the premium of the futures contract to the corresponding cash index. We are generally comparing S&P 500 futures (contract SP or ES) to S&P 500 index. Futures will usually trade at a premium to cash because of the cost of carrying stock vs. cost of a futures contract.
For example, if you want to buy all the stocks in the S&P 500 in the right ratios, you will have to lay out several million dollars. There is a cost to doing this, namely the interest you can earn by putting the same money in a risk free government note, the risk free rate of return. However you will also earn dividends on the stocks you own.
When you buy a futures contract on the same stocks, you put up much less money to control the same amount of stock. Therefore you can earn the difference in interest, but you aren't entitled to the dividends.
Into all this you have to factor how much time until the the futures contract expires (they are dated either march, june, september or december and expire on the 3rd friday of those months). With 3 months to expiry, you have to finance a cash position longer, so the futures premium will be more. At expiry, the futures contract should trade at the same price as the cash index. In a very low interest rate environment with a low dividend yield on the index, the cash can actually trade with a premium over the futures.
"How do you calculate your buy and sell prices"?
Armed with the fair value number for the day (the 10.56 Don referenced above) we can look at where our cash index closed yesterday, where futures are trading pre-market and we can estimate where the cash index will open. From this we can estimate where each stock "should" open as well. Remember to account for dividends, stock splits and the like.
In a nutshell you are fishing for stocks that open too far away from where they "should" for no apparent reason other then some kind of buy/sell imbalance. The thinking goes that the stock will revert towards it's fair value price after the open. How big of a gap is big enough is an open ended question. Smaller gap = lower odds but more opportunity, wider gap = better odds, fewer trades. Most people are somewhere in the .3 to 1% range.
"What about beta"?
Some use it, some don't. It probably does not make a big difference. I multiply the stock's beta by the size of the market gap when calculating the stock's fair value.
"What about news affecting a stock"?
If there is some news event that is causing the imbalance then that may be a whole other kettle of fish. Some people trade this strategy with no regard to news, some spend an inordinate amount of time to remove all stocks with news before the bell. Your call.
"What is an 'opening order', can I use an ecn"?
Your order must be marked as an "OPG" order type. This is a special type of limit order that will either execute on the very first print of the day, and if not executed will automatically cancel. Your orders need to be with the specialist prior to the open, so routing via an ecn won't work.
"How do you know what stocks to trade"?
You send orders on the same stocks every day. Some people will avoid sectors that are not correlated to the S&P 500, like gold and energy.
"How do you enter all your orders, when do you send them"?
You will likely need some kind of basket function in your software or a macro to read your spreadsheet and send your orders. If you only have a handful of stocks you could enter them manually. Send your orders any time inside of 10 minutes to the bell. You can send them sooner, but if the futures move a lot from where you sent, your prices could be off significantly.
"What about exits, do you use stops"?
Once you are in, it's just trading 101. This strategy only gives you an entry with a very slight edge. There is no magic bullet or hard and fast rules how you get out, how you control risk, where you use stops, etc. There is also opportunity cost to consider as the opening is when stocks are most active and this strategy requires attention, so you may miss out elsewhere.
If you have more questions, post them here so we can basically have a FAQ for this strategy. I get tired of typing the same thing repeatedly in emails and pm's.
I realize the OP may not have been refering to opening orders specifically, so maybe we can summarize this in the opening orders thread.
