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The futures price, since it registers the market's expectations of where the actual S&P stocks are heading, often veers substantially above or below the current level of those stocks. When the futures price strays far enough from the real index, it creates a golden door for the arbitrage traders. They play both sides of the gap, knowing they will make money on the difference. For example, if an arbitrager sees the S&P futures price rising well above the S&P stock index, the trader would buy a package of the 500 stocks that make up the index, which are cheap at that moment, and sell the more expensive futures.
Prices could swing up or down before the contract is settled on its expiration date, but because of the original gap in prices, the trader has already locked in a profit, often called synthetic cash. If stock prices rise, the arbitrager will make a handsome return upon selling the shares; the money lost on the futures side of the transaction will not be enough to offset the profit because the price at which the futures were sold was overly high to start with. In the opposite scenario, falling stock prices will cause the trader to lose money on the stocks but more than make up for that loss on the sale of the overpriced futures. The deal is often called a perfect hedge because any money lost by one side of the equation will be more than made up by the other side.
Program trading may bring a safe return for its participants, but it creates distress for other, unsuspecting investors. As traders load or unload enormous amounts of stock, they can magnify the rise or fall of the market. Sharp volatility has occurred at the so-called triple witching hour (on the third Fridays of March, June, September and December), just before stock-index futures and two related types of financial instruments expire at the same time. That is the last point at which arbitragers can decide what to do with the stock they have accumulated, and their herdlike decisions have often wrenched the stock market in wild and woolly one-day movements.