FAIR VALUE
LEARNINGLAB
FAIR VALUE UPDATE
But in the meantime, here is Professor
Stoll’s formula for Fair Value. And as HL
Camp & Company points out on their
website
(www.PROGRAMTRADING.com)
Professor Stoll says the formula is really
very simple.
His Fair Value formula is as follows:
Fair Value = S [1 + (I - D)]
Where "S" is the current S&P 500
Index value.
Where "I" is the amount of interest
paid to your broker to borrow the
money to buy all of the stocks in the
S&P 500 Index. The interest is
calculated based on a percentage
lending rate ® from the current date
(today) until the date that the S&P
Futures Contract expires.
Where "D" is the amount of
Dividends paid to you from all the
companies that you own in the S&P
500 Index. The dividends are paid
to you based on the record dates
for each stock in the Index that are
announced between the current
date (today) and until the date that
the S&P Futures Contract expires.
This dividend income is expressed
as a percentage rate too.
Or in other words, Fair Value is...
...the value of the S&P 500 Index, plus the
interest I pay my broker to buy the stocks
on margin, minus all of the dividend
checks I get.
By the way, the number Mark Haines
quotes on Squawk Box will be different
than what you compute every morning
using this formula. That’s because Mark
is comparing Fair Value to the actual
S&P futures contact that is trading in
Chicago at that time.
ALL ABOUT FAIR VALUE
The Fair Value Screen shown on CNBC each
morning and the pointers CNBC 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 CNBC
puts up the Fair Value screen, or discusses the futures
before the stock market opens, CNBC is
ALWAYS referring to
the next-expiring futures contract. That is referred to
as the front month, but is rarely stated 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.
NOTE: You can get more information on the futures
contracts from the Chicago Merc, whose address is
at the end.
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,
CNBC showS 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 CNBC tries to give viewers a reference point so
they will know whether the markets 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 CNBC does is make a note of that
day’s fair value and then tells 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 CNBC 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
CNBC 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 CNBC constantly reminds
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 CNBC has finished giving an 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
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
wait for sell programs to hit so they
can buy up the blue chips on the weakness.
READING SUGGESTIONS:
Please note: The following
books are may not be still in print. 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.
Instinet Trading
Instinet Corporation is a subsidiary of Reuters
Group PLC. It allows large institutional clients
to trade stocks during non-market hours. That’s
why CNBC will sometimes report on how a
stock is doing in Instinet trading.
Its services are not directly available to individual
investors. Instinet also tells us that right now,
individuals are not able to obtain stock quotes
directly from Instinet. The company is
considering making that information available at
some point in the future.
Individuals may, however, participate in
after-hours trading through a small number of
brokerages. One of them, featured in a story by
Scott Cohn on Thursday, March 5, 1998, is PT
Discount Brokerage (312) 346-3706. Scott
also reported that Charles Schwab also offers
after-hours trading, with some restrictions, as
does San Diego-based Jack White & Co.
According to a company fact sheet, Instinet
provides agency brokerage services in global
equities to security industry professionals in over
30 countries, delivered primarily through
sophisticated computer technology. Instinet
provides its equity transaction and research
services to a global base of institutional fund
managers and plan sponsors, other brokers,
dealers, and exchange specialists.... For
Instinet’s customers, the primary benefit of using
Instinet as their broker is the ability to reduce
trading, or transaction costs, and, in doing so,
improve investment performance.
Instinet’s Web address is www.instinet.com
