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TRADERS CORNER
FAIR VALUE
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Every Saturday morning, people awaken and take a look out the window to
see how the weather. If its sunny, thoughts jump to: mowing the lawn,
taking a jog, playing tennis, waxing the car, taking the kids to the
park, etc… On the other hand, if it is raining ideas shift to: cleaning
out the garage, cleaning the house, reading a book, going to the gym
etc… Many organized people take it one step further by watching the
weather forecast on Friday night to see what is in store for Saturday.
Just like we look to the weather forecast to help us plan our days,
many avid traders and investors view CNBC as the "weather vane" of the
market. They tune in first thing in the morning to see what's brewing;
get some "investment pastries" from Maria, Joe, and "the Brain"; and
then wash it all down with a mug of "Mark Haine's caffeine".
Do you understood what Mark's talking about when he says "Futures, at
plus 8, are right at fair value so the market should open relatively
flat"? Up 8 sounds good, so if the futures are up, how come the market
"should open relatively flat?" What is fair value and how is it
calculated?
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Understanding the Definitions
Futures - Futures are contracts specifying a future date of delivery or
receipt of a certain amount of a certain tangible (i.e. wheat or pork
bellies) or intangible products (i.e. financial instruments like one of
the indexes). In business they are used as protection or "insurance"
against unfavorable price changes and by speculators who hope to profit
from these changes. Futures expire quarterly (Mar, Jun, Sep, Dec) and
when they are quoted it is typically in reference to the "next-
expiring" futures contract.
Index Futures – Index Futures are futures contracts based on stock
market indices - with the most common being the S&P 500. The "futures"
for the S&P 500 and the actual S&P 500 are not the same thing.
Fair Value – (Hang with us here, it isn't as bad as it looks…) To
understand Fair Value, we must first understand the difference between
Present (current "cash") Value and Future (expected) Value. The Future
Value will depend on the length of time until the "future" date, and on
an "assumption" of return. The difference between the current "cash"
value and the expected "future" value is the same as "intrinsic" value
of an option. The Fair Value is the "appropriate" relationship between
the S & P Futures and the actual S&P 500 (cash). This "appropriate"
relationship is expressed through a somewhat complex formula that none
of us really have to understand, but in case you have to see it, it is
copied at the end of this message. Note that the fair value has NOTHING
to do with company, index, or stock market fundamentals or values.
You can find out the "Spread" by subtracting the current S&P 500 value
from the value of the futures contracts. This Spread is called a
"premium" if it is positive and a "discount" if it is negative. Since
most investors assume the S&P 500 index will rise, futures usually
trade at a price higher than where the S&P 500 index is at the current
time and therefore the spread is typically at a premium. CNBC shows
this spread as PREM on the scrolling ticker.
The spread changes throughout the day because the futures contract and
the actual S&P 500 trade independently of each other. When the spread
is at fair value, there is no advantage to owning S & P futures instead
of the stocks that make up the S & P 500. This is a very important
point because when the premium drops below or moves above fair value
enough, then institutions are faced with a choice on whether stocks or
stock index futures are a more attractive investment. When the choice
is made, a flurry of selling one for the other occurs through computer
programs.
This computer-based activity, referred to as "Program Trading," can
often result in sudden swings in the price of certain stocks, or
dramatic shifts in the entire market. In general, when the Spread
(premium) > Fair Value, then stocks are better than futures and it is
likely that computer generated "buy programs" will start kicking off.
On the flip side, if the spread (premium or discount) is less than the
fair value, then futures are better at the time than stocks and it is
likely that "sell programs" will start impacting the market.
Because these computer programs are automatic, it doesn't take long for
the difference between the spread vs. fair value to diminish. As a
result, what initiated the buy or sell program typically goes away in a
very short time period.
Real World Interpretation
Let's see what CNBC is talking about. Assume that at some point in time
we find the following scenario: S&P Futures: 660.00 S&P 500 (Cash):
652.00
Here, the "spread" or "premium" is 8 points, or 8.00. This appears on
the ticker at CNBC at approximately ten minutes intervals next to the
symbol "PREM."
How to Read the CNBC Fair Value Screen
Assume that one morning the "Fair Value Screen" on CNBC looks like
this: Spread 8.00 BUY 10.00 FAIR VALUE 8.00 SELL 6.00
The interpretation is:
Spread - The S&P 500 futures contracts are trading 8 points higher than
where the S&P 500 index closed the night before. (Note that the futures
are traded up until 15 minutes before normal stock market exchange
openings.)
Fair Value - The difference in value between the current S&P 500
futures contract and the futures value, taking into consideration
margin interest, dividends, etc. is 8 points. Note that fair value
doesn't change during the course of a day, but only day-to-day.
BUY – buy programs are likely if the spread reaches +10.00
SELL - sell programs are likely if the spread reaches +6.00
In this scenario, the overall interpretation is - S&P 500 futures are
up 8 but are equal to fair value so the expectation is a flat opening.
Now during the day if you monitor PREM (ticker symbol on CNBC that
flashes by every 10 minutes) against the fair value for the day then
you should be able to anticipate institutional buy and sell programs
kicking off.
So, what about the little futures number in the bottom right corner of
the screen during Squawk Box? This little unit can be confusing because
it doesn't show us what most of us think it is showing us. What it does
show us is the "change" in the S&P Futures contract each morning. A
positive number does not, by itself, mean anything. It must be combined
with information about the previous close and about the fair value for
the day before it makes sense. Fortunately, we don't have to make sense
of it, because Mark does it for us! Just listen for his interpretation
of the number and he will kindly tell you if the change puts the
futures above or below fair value for the day. What a friend! Anybody
that saves us from having to do a lot of math before breakfast is a
pal! If you're in the shower when he tells us what's up, then you are
out of luck and will have to do the math yourself!
How can we use this information? For most traders, this information is
not going to help us make buy or sell decisions on any one particular
stock. However, understanding what is driving the markets at the open
can help you differentiate between program trading (that typically
doesn't last long) vs. "panic selling" or "buying sprees" resulting
from real business or economic information (i.e. the October 1997
crash.)
A Few Final Thoughts
The difference in fair value and the current value of the S&P 500 is an
excellent method to forecast the direction of the market "at the open,"
but once trading starts, things change on the fly! For us small-time
investors, if we had planned to buy or sell at the open, an awareness
of how the market is likely to open is important as we may change our
plan.
Professionals and institutions watch the futures like hawks, and they
are able to react instantly. It's a tough to compete with the big money
using spread information because we don't have the tools and the access
to the markets that they do. We have our own tools that help us succeed
and this just lets us know WHY things are happening so we don't panic.
Remember that futures contracts expire each quarter and as the quarter
progresses, the fair value declines. This increases the likelihood that
the spread will hit buy and sell levels more frequently adding a dose
of volatility to the markets. As an aside, this explains the term
"Triple Witching Hour" which is the last trading hour on the third
Friday of the quarters when equity and index options and index futures
expire concurrently.
Be aware that institutional trading programs do not measurably impact
stocks for the long term. Yes, they scare people and cause some short-
term panic selling, but usually this all ends within a short period of
time (days, sometimes hours, or even less). When the sell programs hit,
it often provides a great chance to pick up some of the blue chips on
the short-term weakness!
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Here's the formula for the brave of heart:
THE FORMULA FOR DETERMINING FAIR VALUE:
F = S [1+(i-d)t/360]
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 yield)
t = number of days from today's spot value date to the value date of the futures contract.
