*ot* I never knew what "futures being above fair value and the indication of a positive opening."
I did some research and heres what it means:
All About Fair Value
by Mark Haines
The Fair Value Screen shown on
CNBC each morning and the pointers
Mark Haines gives 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,
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:
Please note: 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.
www.cnbc.com/moreinfo/0325_fairvalue.html |
