S&P Futures and Fair Value.

Many covered call writers start their day by tuning in to CNBC. They look to the lower right side of the TV screen and see:

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.

Here’s an example of what you may see on CNBC prior to market open:

Fair value and futures

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 inherent in program trading. It will also give some meaning to that screen we have been staring at in the morning for all these years.

Market tone:

The housing industry is showing positive momentum and that bodes well for our economy and our stock market. This week’s economic reports:

• October national median price of homes is up 11.1% from a year ago
• Year-over-year sales of ALL homes have increased in 8 consecutive months
• Sales of existing homes were up 2.1% in October despite the impact of Hurricane Sandy in the northeast. These sales are up 10.9% from October, 2011
• Total home inventory was down 1.4% from September to a 5.4 month supply
• New residential construction rose 3.6% in October to an annual rate of 15.1%. This was the 3rd straight month of rising housing starts
• The Conference Board’s index of leading economic indicators rose for the 2nd straight month
• Fed Chairman Ben Bernanke reiterated that Fed policy would remain “accommodative” until the economy is stabilized

For the week, the S&P 500 rose by 3.6% for a year-to-date return of 14%, including dividends.

Summary:

IBD: Market in confirmed uptrend

BCI: Moderately bullish but short-term cautious due to “fiscal cliff” issues. This site continues to favor in-the-money strikes, low-beta stocks and ETFs until our Congress moves forward with a deal that avoids tax increases to all and cuts to important economic programs.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com