No problem.
Here's CNBC's viewpoint. I would have just posted the URL but it changed so I only have the text of the message.
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Squawk@CNBC.com
Traders Digest
Peyton:
Am sending you a copy of Fair Value synopsis to post, with the understanding that it is credited to CNBC. Please note that it was
intended for a general audience, like CNBC's. Sophisticated traders of futures may find it somewhat simplistic, but that was the
intent, to keep it simple.
Mark Haines ===================================================================
The Fair Value Screen shown on CNBC each morning, and the pointers I give
every morning as to the meaning of the then-current futures change reflect
the reality of a mathematical relationship between the futures and the S&P
500 index, which is referred to as ?the cash.? This subject is as easy as you
want to make it, or as complex as you can imagine. It all depends on how
deeply you want to understand the process. For most people it is not
necessary to know much more than what is in this explanation. At the end, I
will give you some references for further information.
PLEASE NOTE: The following information is about a phenomenon in the stock
market which is completely unrelated to what most investors would consider
the ?fair value? of stocks. THIS fair value has nothing to do with company or
stock market fundamentals. It is strictly a technical approach, and one which
has on occasion seriously roiled the markets. For that reason, I think it?s
important for people to know what is going on, even though there is little or
nothing you can do about it. Some may try to ?go with? the programs, others
may try to go against them on the theory that the price moves are
?artificial.? Most should probably just use the information as a way to
understand, to get neither too excited, nor too scared, when the market
suddenly soars or drops because of program trades.
THE BASICS
Understand first that there are futures contracts on the S&P 500 that trade
at the Chicago Mercantile Exchange, completely independent of the S&P itself.
The contracts expire quarterly. They are March (SPH on the ticker), June
(SPM), September (SPU), and December (SPZ). When we put up the Fair Value
screen, or discuss the futures before the stock market opens, we are ALWAYS
referring to the next-expiring futures contract. That is referred to as the
?front month,? but we rarely say ?front month? because that is simply
assumed. So, in late March, after the March contract has expired, and in
April, May, and early June, the ?front month? is the June contract. A day
before the June expires, September becomes the front month, and so on. You
can get more information on the futures contracts from the Chicago Merc,
whose address is at the end of this paper.
These contracts, because they are a ?bet? on where the S&P will be at a point
in the future, almost always trade at a price higher than where the S&P 500
index is at the same time, because most people assume stocks will rise. On
rare occasions, the futures will trade below the actual S&P 500, which is
referred to as a ?discount.? The difference between the two ? the futures and
the cash (remember, ?cash? is just a shorthand term for the S&P 500 index
itself) ? is called, on CNBC, the ?spread? or ?the premium? (since the
futures are usually at a premium to cash). Example: Assume at a given point
in time:
S&P Futures: 760.00
S&P 500 (Cash): 755.00
Here, the ?spread? or ?premium? is 5 points, or 5.00. This appears on our
ticker at approximately ten minutes intervals next to the symbol ?PREM.?
FAIR VALUE
?Fair value? refers to the ?proper? relationship between the futures and the
cash. Through a complex formula using current short term interest rates and
the amount of time left until the futures contract expires, one can determine
what the spread between the futures and the cash ?should? be. The actual
formula for determining fair value is reproduced at the end of this paper.
When the spread is at fair value, where it ?should? be, there is no
theoretical advantage to owning the futures instead of the cash, or vice
versa. To professional investors and the big institutions, when the spread is
at fair value, it makes no economic difference to them whether they own the
futures or the actual stocks that make up the S&P 500. Their buy and sell
decisions will be driven by other factors. But, when the spread drops below
fair value or moves above it by a large enough margin, then one of the
choices (stocks or futures) will become more attractive than the other, and
they will sell one and buy the other.
The spread or premium changes throughout the day because, as I said earlier,
the futures contract and the actual S&P 500 trade independently of each
other. Supply and demand in the futures pit in Chicago determines the price
of the futures contract. Supply and demand for ALL 500 stocks in the S&P
index come together to collectively determine the price of the cash S&P 500.
Sometimes, these forces go in opposite directions, or in the same direction,
but at different speeds. When that happens, the spread changes.
FAIR VALUE SCREEN
Assume for this example, that on a given morning, the Fair Value screen we
show on CNBC looks like this:
Spread 5.00
BUY 6.00
Fair Value 5.00
SELL 4.00
Since we show this before the market opens, this means:
1. The front month S&P 500 futures contract closed last night 5.00 higher
than the actual S&P 500 index, for a ?spread? or ?premium? of 5.00.
2. Fair Value for that day (which is provided to us by Prudential
Securities) is also 5.00. FAIR VALUE DOES NOT CHANGE DURING THE DAY. However,
as each day passes, it gets a little smaller, because the time left until
futures expiration is part of the value.
3. BUY programs are likely to be triggered if/when the spread widens to
6.00.
4. SELL programs should be expected to hit stocks if/when the spread narrows
to 4.00.
NOTE: The ?buy? and ?sell? levels are not exact. Since borrowed money is used
by the arbitrageurs (arbs) who play this game, and since the cost of
borrowing can be slightly different for each arb, the exact point at which
these trades become profitable varies.
This is all you really need to know. It is like a tide table, telling you
when the tide will come in or go out. But, if you want to know some of the
workings behind this, read on.
As an example, assume the market opens with the spread at fair value. But, as
trading begins, as mentioned earlier, the futures and the cash go their
separate ways. If the spread widens to 6.00, the institutions will find
stocks more attractive to own than the futures contract. So, they BUY stocks
and SELL the futures. That is why that number is labeled ?BUY.? If the spread
narrows to 4.00, in this example, the institutions will SELL stocks and BUY
futures, because their models tell them they will make more profit that way.
So, by monitoring the spread (which appears on our ticker labeled ?PREM?),
one can get a good idea of whether to expect sudden selling or buying by the
institutions.
NOTE: The act of selling something tends to depress its price, while buying
it tends to raise its price. So, the programs that the institutions trigger
tend to drive the spread back to fair value very quickly. With a wide spread
between the futures and the cash (the futures are too expensive relative to
fair value), buying stocks and selling futures drives the cash index up and
the futures down, which NARROWS the spread, returning it to fair value.
Therefore, the effect caused by hitting these buy and sell levels can be VERY
short-lived.
PRE-OPENING DISCUSSION
In the lower corner of the screen on Squawk Box, we show the change in the
S&P Futures contract each morning. Unfortunately, this information alone can
be misleading, and there is not enough room on the screen to put up all the
relevant numbers. So, each morning I try to give viewers a reference point so
they will know whether we are in ?BUY?, ?SELL?, or ?FAIR VALUE? territory.
Here?s the way it works, and why it can sometimes seem confusing:
Before the market opens, we know exactly where the S&P 500 (the cash) closed
the night before, and, of course, it is closed, so it is not changing. But,
the futures ARE trading in Chicago. In fact, they trade all night and up to
9:15AM ET. So, during those pre-stock market hours, the spread is changing as
the futures trade. What I do is make a note of that day?s fair value and then
tell viewers what change is needed in the futures to reach fair value.
Example:
S&P 500 closed previous evening at 760.00.
Futures closed previous evening at 762.00. (Spread or premium is 2.00)
Fair value that day is 6.00.
The futures ?bug? on the screen says ?+4.00?
Here, the futures closed at only a 2 point premium to cash (this is possible
because the futures continue to trade for a few minutes after stocks have
closed, so they can wander off in their own direction). But, this morning, in
the futures session that occurs before the stock market opens, the futures
are up another 4.00, to 766.00. So, at +4.00 we are at exactly fair value ..
the spread or premium is now 766 (futures price) minus 760 (S&P 500 price),
or 6.00. So, you would hear me say something like, ?The futures, at plus 4,
are right at fair value, and they will therefore not be a factor at the
open.? Up 4.00 sounds good, until you realize that what counts is where we
are, relative to that day?s fair value.
But, suppose in this example, the futures were up only 2 points. The ?bug?
would say ?+2.00.? To someone who doesn?t know fair value, that would seem to
be a positive .. the futures are UP! But, the reality would be this:
S&P 500 closed previous evening at 760.00
Futures closed previous evening at 762.00. (Spread or premium is 2.00)
Fair value that day is 6.00.
The futures bug says ?+2.00?
Since fair value is at 6.00, and the futures at +2 would be at 764, the
spread is only 4 points (764.00 on the futures, 760.00 on the cash,
difference is 4.00). While the futures are up, they are still BELOW fair
value, and therefore, they would have a NEGATIVE influence on the opening of
the stock market. In this case, you would hear me say something like ?Even
with the futures up 2, they are well below fair value and are a negative for
the opening. We need to get to plus 4 in order to be at fair value.?
Also note that it is possible for a declining futures price to still be a
positive. If the futures and cash closed far enough apart the night before,
say by 8 points, then a 1 point decline in the futures would still leave a
spread of 7 points, which, in our example, would be enough to trigger buy
programs at the open.
THINGS TO BEAR IN MIND
First, the predictive value of the spread is very certain, but also very
short-lived. In the morning, the effect is gone within the first few minutes
of trading. The spread can tell you which direction the market will go AT THE
OPEN, but once trading starts, things change quickly. Its primary value for
the average investor is probably in the area of ?market on open? orders.
People who instruct their brokers to buy or sell when the market opens should
be aware of how the open is likely to go. Its secondary value is ?peace of
mind.? Knowing that program trading is likely at the open, investors are less
likely to become overly concerned if the market drops sharply in the first
few minutes. It isn?t people selling because they know something you don?t,
it?s program trading that will probably run its course in a matter of
minutes.
Second, the spread itself can change very quickly in the pre-opening
session. There are not a lot of traders working, and the contract can make
big moves in a flash. That?s why I constantly remind viewers that the futures
are indicating thus-and-so RIGHT NOW, but could change by the time 9:30 AM ET
arrives.
Third, professionals and institutions are watching the futures like a hawk,
and reacting instantaneously. By the time I have finished my explanation of
what the futures are indicating, the big money has already reacted. They are
WAY ahead of the average investor. The value of this information is that it
tells you what to expect the big money to do. But it rarely gives you a head
start because the institutions have the computer power that figures out all
the possibilities and spits out buy and sell orders in less than the blink of
an eye. So, it should be treated merely as another piece of the puzzle,
information that lets you know WHY things are happening, not necessarily
information that puts you on an even footing with the big guys.
Fourth, sell programs (sell stocks, buy futures) require less margin (less
borrowed money). One can buy a futures contract on 90% margin, but one can
use only 50% margin to buy stocks. So, there is a natural bias toward having
more sell programs than buy programs.
Fifth, as each quarter progresses (remember, the futures contracts expire
each quarter) the fair value declines, increasing the likelihood that the
spread will hit the buy or sell level.
Sixth, despite points 4 and 5 above, which show the table titled in favor of
sell programs, the Dow Industrials are up roughly 5,000 points since such
program trading came into existence. This proves, to me at least, that while
the programs are something we should all be aware of, they have NO measurable
long term impact on stocks. They blow through the market and sometimes create
quite a fuss, perhaps panicking some into selling out, but days, and
sometimes only hours, later, prices are right back where they started. In
fact, some professional traders I know wait for sell programs to hit so they
can buy up the blue chips on the weakness.
READING SUGGESTIONS:
I do not know if any of the following books are still in print. And, there
may be others on the subject that I am not aware of. A trip to a good-sized
library or book store will probably help find some or all of them, or you
could try calling the publisher.
The Business One/Irwin Guide to the Futures Markets, Kroll & Paulenoff,
Business One Irwin, Homewood, IL, 1993. See chapter 26.
The Dow Jones-Irwin Guide to Stock Index Futures and Options, Nix & Nix, Dow
Jones-Irwin, Homewood, IL , 1984.
A Handbook for Professional Futures & Options Traders, Koziol, Joseph D.,
John Wiley & Sons, NY, 1987.
Financial Futures Markets, Brown & Geisst, St. Martin?s Press, NY, 1983.
Handbook of Futures Options: Commodity, Financial, Stock Index, and Options,
Kaufman, Perry J., John Wiley & Sons, NY, 1984.
Trading Financial Futures, Labuszewski & Nyhoff, John Wiley & Sons, NY, 1988.
Index Options and Futures: The Complete Guide, Luskin, Donald L., John Wiley
& Sons, NY, 1987.
In addition, information is available from the Chicago Mercantile Exchange,
which is where the S&P 500 index futures trade. Their website is at
www.cme.com. Their mail address is: 30 South Wacker Drive, Chicago, IL 60606.
Their telephone is 312-930-1000.
FORMULA FOR DETERMINING FAIR VALUE
F = S [1+(i-d)t/360]
Where F = break even futures price
S = spot index price
i = interest rate (expressed as a money market yield)
d = dividend rate (expressed as a money market yield)
t = number of days from today's spot value date to the value date of the
futures contract.
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