You turn on CNBC early one morning:
The S&P Futures are UP 5 points…..GREAT!!!!!!!!!!
Fair Value is + 10…….what’s that mean?
The market is expected to open DOWN…….ughhhh……why?
To understand how this works, we need to first understand the relationship between a financial index (in this case the S&P 500) and its index futures:
The S&P 500 Index- This is an index of 500 stocks chosen for market size (large cap), liquidity and industry grouping. It is one of the most commonly used benchmarks used to reflect the overall U.S. stock market.
Index Futures- These are contracts specifying a future date of delivery of the underlying instrument (the S&P 500 index). Buying or selling a futures contract represents a bet on the future direction of how the index will behave over time. Its value fluctuates according to what traders are willing to pay for it. The futures for the S&P 500 and the actual S&P 500 are NOT the same thing. Since stocks historically rise in value (although you couldn’t tell that from the debacle of 2008!), the futures lead and are generally higher than the actual index. These contracts expire quarterly (March, June, September and December) and are usually quoted in reference to the next expiring futures contract. The most active trading occurs in the near-month contract.
Fair Value- This is the relationship between the futures contract or expected value in the future and the present value or current cash value of the index. When calculating fair value, investment banks and brokerages must also factor in borrowing costs to own all the stocks in the index as well as the dividends that are NOT received by those who own the futures contracts. For example, if the fair value is calculated @ +5, the futures contract needs to be 5 points above the cash index’s (S&P 500) close the previous day to be at its fair value relationship to cash. If it is, then the present value and future value are equal and traders are expecting no change in the market value of the index. However, if before the market opens, the futures are trading above the fair value of +5, stocks are likely to open higher. Fair value does not change during the course of a day, only day-today.
Hypothetical Example:
- The S&P 500 Index closes Monday @ 1000 (4PM, EST)
- S&P futures closed @ 1005 (9:15 AM)
- Fair value for the futures, when factoring in borrowing costs and lost dividends, was calculated to be 1010 or + 5.
- On Tuesday morning when futures ended their overnight trading (9:15 AM, EST), the price was @ 1015 or 5 points higher than their fair value relationship to cash value of the S&P 500 index. This indicates a higher market open. Had the futures ended their overnight trading @ 1005 that would have been 5 points lower than fair value indicating a lower opening.
Program Trading:
When the spread is greater or lesser than fair value, institutional computerized programs kick in to buy or sell stocks. If the spread or premium of futures as it relates to cash (S&P 500 Index) is greater than fair value, the market will see a higher open. If the spread is lower than fair value, the market will open down. These programs are automatic and will quickly diminish the difference between actual spread and fair value. This will create a temporary volatility in the market which will quickly calm down. This is one of the reasons that I do not like to trade early in the trading day…too much volatility potential.
Arbitrage:
Fair value also has relevance during the trading day when both the S&P 500 index and the futures trade simultaneously. The two normally trade in a fair-value relationship but when there is a discrepancy arbitrage traders jump in to take advantage of the temporary difference. For example, if the futures are trading above the fair value to S&P index price, a trader can sell the contract and then buy it back when it returns to the normal relationship. The trader profits in the difference between the sale and buy-back prices.
Conclusion:
Understanding the concept of fair value as it relates to S&P futures and the index itself will not influence stock or option selection. What it will do for us is to explain the driving forces behind a market open and differentiate program trading from panic selling and buying sprees which are driven by business and/or market conditions. It may also guide us to avoid early morning trading to avoid the potential volatility inherant in program trading. It will also give some meaning to that screen we have been staring at in the morning for all these years.
Welcome to our new premium members:
A warm BCI welcome to our new members both here in the US and abroad. Two questions that have come up recently involve the new term “other” used in the report and the broken black lines found in the “running list”. We incorporated the term “other” last week (on pages 1 and 2 of the report) when our database expanded to many thousands of stocks screened each week. These stocks are “other” than those found in the IBD 50. In the chart below I have highlighted in yellow the column where this information is located:
Premium report top 50 plus "other stocks"
In the running list on pages 3 and 4 of the report the broken black lines will categorize each group of stocks according to the expiration month. We base this on current information with the understanding that a company can change an earnings report date as that date approaches. The red arrows in the chart below point out these lines:
Earnings dates categorized
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Unemployment rate for March dropped to 8.8% the best level since March, 2009
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The Conference Board’s index of consumer confidence fell to 63.4 after reaching a 3-year high of 72.0 in February
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Construction spending in March dropped by 1.4% continuing a 3-month decline
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Personal spending increased in February by 0.7% doubling the January rate
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Factory orders for manufactured goods disappointed by declining 0.1% in February
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ISM’s index of manufacturing activity remained above the 60 level, a sign of strong growth
For the week, the S&P 500 rose 1.4% for a year-to-date return of 6.4% including dividends.
Summary:
IBD: Confirmed uptrend
BCI: This site continues to have a cautiously bullish outlook on our economy and stock market. I have been adding more out-of-the-money strikes to my portfolio as economic recovery signals strengthen.
Much success to all,
Alan (alan@thebluecollarinvestor.com)
Alan,
Great article, thanks. You mention that you don’t trade when the market first opens. Is there a guideline or time frame you use to place most of your trades?
Thanks agian.
Barbara
“Fair value does not change during the course of a day, only day-today.”
I am a little dense this morning. I understand the sentence, but not the last 3 words.
Thanks
Alan,
Curious why you use the words “cautiously bullish” rather than just bullish when describing you market outlook. The first quarter has been a good one. Shouldn’t we be more optimistic and aggressive?
Tim
Barbara (#1),
I will normally execute my trades between 12PM and 3PM EST. This can be stretched to 11AM to 3:30 PM if the above is not convenient. The exception to this guideline is when I roll my stocks on expiration Friday. If I am at my computer as we approach 4PM EST I may wait closer to 4PM to allow time value to deteriorate. The main point I make here is that early morning and late afternoon trading may be volatile and SLIGHTLY impact our bottom line. For example, we may buy a stock at 9:30 AM EST and by the time we sell the option, the price has dropped more than a few pennies.
Alan
John (#2),
Good question. Tomorrow morning we will see the fair value stat on our TV or computer screen that will NOT change during the course of the trading day. Prior to market open on Tuesday, fair value will be recalculated by investments banks, brokerages and others and that stat will change (usually). So the fair value will not change during the course of the trading day but will change from one day to the next. An analogy we can use is the NAV (net asset value) of a mutual fund which does not change price during the course of the trading day but will be re-evaluated from day to day.
Alan
Alan–
You mention the problem of buying a stock and then finding that the option premium has decreased before you can actually sell the call and complete both of the transactions..
What about using Buy-Write to treat the entire transaction as a single unit rather than two parts( stock and option).
mike
Tim (#3),
I qualified the term bullish because of the uncertainty created by global circumstances like in Libya. The conclusion I came to (laddering strikes) can be viewed differently depending on one’s risk-tolerance. Some of our members are selling only out-of-the-money strikes thereby creating opportunities for greater returns at the cost of less protection. Different strokes for different folks.
Alan
Mike (#6),
You make an excellent point. If your online discount broker offers a combination form where you can set a “net debit” order it will solve part of the problem created by a volatile open or close. That is, it will guarantee the option return (ROO) that meets your goals. However, I still prefer not to trade in a potentiallly volatile environment. With both trading approaches (legging-in and buy-write forms) the stock is being purchased in what may be inflated conditions and that may impact our bottom lines if the stock price falls back to a more normal trading situation. My feeling is why not wait for market conditions to settle? For new members who may not be familiar with buy-write combination forms, here is a link to an article I published in 2009:
http://www.thebluecollarinvestor.com/blog/buy-write-combination-order-form-plus-charts-of-the-week/
Thanks for contributing this valid point.
Alan
Premium members:
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The BCI team
Thanks Alan,
for the very informative article.
Funny thing is, that the question about the relationship between S&P futures and the high or low market opening was on my list for this week.
Answered perfectly, like always!
Cheers
Dirk
Alan,
On the premium report should we favor top 50 vs. “other” stocks or give them all equal weight?
Thanks,
Amy
Hi,
I am a new member to this site. I am reading the technical analysis chapter in Alan’s book and I finally feel that I can read a stock chart. Can anyone tell me how often I should check these charts or should I just check them when I am ready to make a trade.
Any help is appreciated.
Kim
My two cents:
Read them as often as you can.
Preferably the ones, which you want to use for cc.
Then you get familiar with the movements of that particular stock.
And there is no substitute for repetition!!!
Cheers
Dirk
Kim (comment #12),
Dirk is correct, but don’t stop keeping an eye on them as long as you have the position open. You don’t want to look at the technicals on Friday and discover last Tuesday is a good day to close the position. This does not mean that you must study them every two hours, but this is not buy and forget investing. We trade in monthly increments, so you need to pay attention to movement or news that may effect your trade.
Amy (# 11),
Over the years I have had my greatest success using the IBD 50 (formerly IBD 100) list as my starting point. I have also utilized other resources described in my books.
The BCI team has developed a database of securities over the years and we have invested in an expanded screening system that allows us to screen thousands of stocks that meet our strict system criteria.
ALL the stocks that pass our system screens either from the “top 50″ or our huge expanded database (“other”) are great candidates for 1-month covered call writes.
Alan
Owen and Dirk,
Thanks very much for your advice. I agree the more you study something the better you get at it. Thanks for your support.
Kim
Alan,
Do you favor in the money options the month before an earnings report is coming out? Seems to make sense since you want to sell the stock anyway.
Fred
Here is another example of a shot coming out of left field to ruin your day. I have an Apple put spread, sold the $335 put and bought the $325 put. This morning it was announced that Apple’s percentage of a couple of indexes will be reduced because the price has gotten so high it has the index has become lopsided toward Apple. That is going to cause ETFs and other index funds to sell enough Apple to get the new percentage figure. Apple is expected to open around $335.
Fred (#17),
You make an excellent observation. Since we will not use that equity the next month why not sell an in-the-money strike and allow assignment. This will give us an initial return that meets our goals and the extra protection against share depreciation.
However, if the market tone is bullish and the stock technicals are positive, I will oftentimes sell an out-of-the-money strike to take advantage of potential share appreciation. I evaluate the current circumstances and decide which strike will give me the best chance to generate the greatest returns.
Alan
Has anyone had success selling calls on stocks with high dividends?
Thanks.
Barbara
CAGC
Does anyone know when this stock will resume trading? Trading on this stock has been frozen for weeks…
Thanks
Dave
Dave,
Looks like trading has been halted for an investigation…
http://www.nasdaq.com/aspx/company-news-story.aspx?storyid=201104012355MRKTWIREUSPR____0739940
Tim
NVO:
This leader in insulin and diabetes care has been on our premium watch list for 4 weeks. On February 2nd it reported the 4th quarter earnings with a 23% increase in sales and a 74% increase in earnings, year-over-year. The company expects an 8-10% sales growth in 2011 with an operating profit of 15%. Although it trades at a robust 23.8 x forward earnings, the PEG is a reasonable 1.4.
We can see from our premium report that the segment rank is “B”, beta is 0.83 and provides a dividend yield of 1.10%.
Alan
Barbara( #20) and the BCI community,
There has been a significant amount of interest from our members regarding a strategy where we use covered calls (LEAPS) to enhance the returns of high dividend yield stocks.
I am in the process of completing an article that will describe a procedure to maximize the success of such a strategy. I received confirmation today from a former options market-maker about my ideas and will publish the article for all our members within the next two weeks.
Alan
Alan,
I am one of your members who emailed you about the dividend strategy. I’m looking forward to your article. Are you also going to suggest the best stocks to use?
Thanks for your help.
Steve
Steve,
Locating stocks for this strategy is a challenge but one that can absolutely be overcome. I have been running scans for the past few weeks with the newly enhanced database of BCI stocks. When I publish this article either this weekend or next, I will list the criteria used in the screening process and a few examples of stocks that pass the screens as of the published date.
Alan
Slowly but surely, I have been reading the articles and blogs in the past archives. I am a rookie, and have been learning the nuts and bolts of CC writing for the past six months. While reading in the archives, I find invaluable information that does not have to deal with books or webinars, but Alan’s and members personal experiences in CC writing. For example, Alan normally trades between 12 to 3pm, because its less volatile. Another was how to deal with the bid and ask spread. These little tidbits would take years to accumulate by ones own experiences. Alan, would it be possible if you could do article on a few of your experiences and then let the rest of us blog in our ideas (especially the veterans.)
Thanks,
Bill
BTU is below $70 this morning. I have sold $70 and $75 calls. The $75 is at 15c – do I buy it back – the ER is Apr 19 and sell a May on Wed after the ER or roll it forward now for a nice profit? Same with the $70?
Bill (#27),
Your two examples are actually based on my experiences. Since I am self-taught the rules and guidelines that I present in my books, DVDs and website are based on mistakes I made and then corrected. One of the mission statements of the BCI system is for our members to master this strategy without having to make those same mistakes. Another example is trading through earnings reports. After getting “hammered” a few times this rule was put in place.
If I haven’t fully understood your suggestion please give me an example as we always try to be responsive to our members.
Thanks for your kind words.
Alan
Frank,
In the third week of a 4-week cycle, I will generally buy back my option when the price is 10% or lower than the original option sale price. This would probably apply to the $75 strike and not the $70 strike (depending on the price you received).
Once you buy back the option, you can roll down or sell the stock depending on your outlook. “Hitting a double” is a choice also but with only 6 trading days left until expiration there is little time for a significant recovery (but possible).
For example, if you buy back the $75 call for $0.10 and sell the $70 April call for $0.60, you will generate an additional $50 per contract by this rolling down strategy. This may mitigate losses or add to gains depending on the original trade.
As far as re-entering a new position after the ER, this will depend on whether the stock meets our system criteria after the report.
Alan
Alan
I think it is fantastic that you answer questions. Just wanted to thank you for this wonderful service.
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Alan and the BCI team
Two weeks ago I bought FOSL for 88.28 and sold the 90 option. Today the stock is priced at 94.02 and I can buy back the option for 4.40 losing 38 cents in time value. Does it pay to buy back the option this late in the contract or let the stock get sold since the earnings is set for May 11?
Thanks,
Barbara
Barbara,
You have the right idea regarding the mid-contract unwind exit strategy but the question is more about whether to execute this strategy with 5 trading days remaining for the April contracts.
You have a $38/contract loss or debit to unwind. That is .4%. If you can generate a greater return in the remaining week for a low-risk investment you may want to move forward. However, to do so would involve selling an at-the-money strike with no protection and little time for exit strategy repair should the stock decline in value. I would consider this strategy in the final week of a contract when the market is strongly bullish and the new stock technicals are all-confirming.
Alan
Hi Barbara,
with a possible government shutdown today I would buy back and sell the stock.
Maybe its just me, who is scared, but the last time we had a situation like this, the major indexes went down about 5% the week after the shutdown.
If this happens, and it is like y to happen with the Kindergarden we have in Washington, you might not get called on your stock and have to wait some time for recovery.
FOSL is down to $93.77 right now, and even cheaper to buy back.
Cheers
Dirk
Alan and Dirk,
Thanks for your information. I was torn what to do so I closed one contract and kept one.
Barbara
To our BCI community:
I just completed an article involving the use of covered calls and high dividend yield stocks. This subject has been discussed on this blog so I decided to take action. My goal was to form guidelines that will help maximize returns, minimize risk and decrease the possibility of early exercise. My ideas were confirmed by a hedge fund manager and a former options market maker. This is a NEW strategy to add to our BCI arsenal and will be particularly appealing to conservative investors. I will publish this article on Saturday.
Alan
Thanks gain Alan,
with all the blogging, articles, answering e-mails and pulling some teeth in the meantime, when do you have time ti sleep? :>)
@ Barbara,
wise decision. You can’t get wrong with that. . .
Cheers
Dirk