Option Investor

Daily Newsletter, Saturday, 07/23/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Oil Lubricates Gains

Oil Lubricates Gains

Oil rebounded on Friday from three-week lows and the rebound in oversold oil stocks powered the market higher. The S&P remained stubbornly in positive territory on Friday while the Dow and Nasdaq struggled to find buyers and languished in the red. Almost single handedly the rebound in the oil sector, led by the OSX, pushed the S&P steadily higher. A late day buy program provided the final spark that triggered yet another short covering spree. These factors combined to rescue the indexes from closing negative for the week.

Dow Chart - Daily

Nasdaq Chart - Daily

It was a tough week for stocks as alternating good news/bad news earnings reports competed for the spotlight. Good earnings news was matched with either higher expectations or lower guidance and many stocks were knocked for huge losses. On Thursday and Friday there were over 25 companies that either posted lower profits, missed estimates or warned on future guidance. Still, the markets failed to crack and we remain pinned to the recent highs. Buyers are all trying to chip away at this resistance but are only showing marginal gains for their efforts. The good news may actually be the lack of a drop. They tried to take the indexes lower several times but were unable to make any progress in that direction either. The result is a range bound market that is murder on traders.

TThe economic news for the week was dominated by the dual appearance by Greenspan in his biannual testimony on the state of the economy. It was clear from his remarks that there is no end in sight for rate hikes and a 4% ceiling is just wishful thinking by investors. He also continues to claim the economy is on firm footing and growing steadily. Another good news bad news event with steady growth offsetting the fear of higher rates. The market shook off any rate/inflation fears and tried to move higher. This was likely the last testimony to be given by Greenspan who faces mandatory retirement in January.

On Thursday the government reported that Jobless Claims for the prior week fell -34,000 to 303,000. This was the lowest level since April but there could be trouble on the horizon. This week turned out to be the biggest week for announced layoffs since January 2001. Leading the list was HPQ with a cut of -14,500 and KO cutting -10,000. Automakers continue to cut staff with the total cuts for the year at -78,000 for this sector. These were just some examples but there were many others. The cuts announced were scheduled for many months into the future so next weeks Jobless Claims should not show a sudden spike but there are growing signs of employment problems contrary to this weeks Jobless Claims drop. Next Tuesday's Monthly Mass Layoff report could show signs of an accelerating layoff cycle.

This was an off week for economic reports with a very light schedule but those that did appear showed strong gains. The Philly Fed Survey jumped to 9.6 from -2.2 and the Chicago National Activity Index rebounded to 0.28 from -0.03. Next week starts out slow but finishes with a bang on Friday with the GDP, NAPM, ECI, PMI and Consumer Sentiment.

This was a very strong week for earnings bringing the total S&P companies reported to 145. 72% have beaten estimates, many times lowered estimates, 15% announced inline and only 13% failed the earnings test. Analysts credit this imbalance with the dumbing down of guidance due to Sarbanes Oxley concerns. Next week we have 153 S&P stocks and four Dow stocks reporting. Actual earnings have averaged +9.1% growth and slightly ahead of estimates of +8.4% growth. All things considered, even discounting INTC, MSFT, GOOG and YHOO, it was a decent quarter. Earnings growth is decelerating but the outlook is still healthy. It is just not as good as we have seen over the last two years. The real question is not what level is considered good at this stage in the cycle but is this level of earnings growth and guidance sufficient to push the markets higher? So far earnings have been good but guidance has been only fair. Still the markets failed to sell off and the stalemate continues.

Last week oil prices fell to three week lows and took energy stocks along with it. Fortunately other stocks were reporting earnings and offsetting the weakness in energy. On Friday energy stocks were bolstered by the OSX led by comments from Haliburton and Schlumberger. Haliburton, the second largest services company, said they expected energy prices to stay high. They said customer spending in the exploration sector was very strong and the chances for it to continue were very good. They said world economies appeared to be absorbing the higher prices with minimal impact to GDP. Schlumberger said its profits jumped +36% on rising demand as customers worldwide stepped up their exploration activities. They said they saw this demand increasing driven by the lack of spare production capacity in the industry. SLB said there was more than enough work for everyone as they themselves were stretched thin by the increased demand. Both companies beat earnings estimates, which had been raised continuously by anxious analysts. Energy stocks rocketed out of their doldrums with many of the OSX stocks hitting new highs. Examples included gains in DO +3.50, RIG +3.35, NE +3.62, BHI +2.61, WFT +2.68, APA +3.86, SUN +5.06, NBR +3.56, EOG +3.30, BR +3.32, HP +3.04, VLO +3.63, AHC +5.51. Oil prices soared as well to $58.70 and a +$1.52 gain. This was well off Thursday's low of $56.50.

DDecember Crude Chart - Daily

The strength in oil and the OSX not only supported the S&P but pushed it back to a close at 1233. Energy stocks comprise 14% of the S&P and with average earnings at 35% they will be the main reason S&P earnings remain in positive territory for Q2. I continually get comments from various readers and analysts suggesting increasing supply from new exploration will solve the oil problem. Most expect oil to return to under $40 levels and last for decades to come. I believe it is easy to speculate if your money is not at risk. I believe if anyone takes the time to research the subject they will come to the same conclusion that oil prices may ebb and flow but they will continue to rise forever. I traded emails with a reader this week and I am going to reprint some of that conversation here for your consideration.

I doubt anyone has a real handle on where oil is going. From the reports I read there are estimates of $40 to $75 but most of the oil commentators have not really researched the problem and are just talking from past experience and assuming those price ranges will continue.

Globally more than 30 million cars and light trucks are produced each year and growing. Less than 5 million are scrapped. (China is on track to produce more than 5.2 million cars in 2005 yet only 6 people per thousand have a car in China) Nearly 2 million large trucks are built. Over the road trucking is growing by leaps and bounds. Diesel usage is at all time highs and growing rapidly as more and more products are shipped by truck. Jet fuel demand is at an all time high with demand rising about 4% per month. All of these uses depend on light crude not heavy OPEC crude. Only a few refiners can crack the heavy crude into the "middle" distillates of diesel, jet fuel, etc.

Global population is growing by 75 million people per year according to the U.S. Census Bureau. Every new person consumes products made with oil and shipped in a truck. That usage accelerates as they begin working, driving, raising a family, etc. Even if each new person ONLY consumed a minimum of 1 bbl per year that is an extra 205,000 bbls per day of additional demand every year. Since consumption from (China) is 1.9 bbl per person per year and consumption in the U.S. is 26 bbls per year per
person you can extrapolate that average global consumption per person in advanced nations is probably more in the 2-3 bbls range. India has the lowest current consumption for a major country at 0.8 bbls per person but their demand growth rate is likely to exceed China by 2010. India could easily consume more oil per person than China within 3 years. Population in India is 1.08 billion, China has 1.3 billion. As each country accelerates into the 21st century their oil consumption per person could easily grow to that 2-3 bbls per person. Do the math. That is an extra 3 billion bbls per year. We only produce 3.1 billion bbls per year now. It would require doubling our existing production at a time when we are having trouble just staying even. Even if only 25% of those estimates come to pass there is no way we could produce that much oil.

These global usage tends to be ignored because they are so mundane but every drop used comes from somewhere. Eventually something has to give and the only answer is higher prices and less oil. You can't pump over 3 billion bbls a year forever. Once productive but now dry holes are being plugged almost as fast as new wells can be drilled. 43 nations have declining production. Only 3 nations can increase production materially, Saudi, Russia, Venezuela. Saudi and VZ produce mainly heavy crude with VZ production more like sludge than oil. Current daily global production is around 85 million bpd. Production from existing fields as quoted by numerous experts is declining at something between -5% and -7% per year. That means those fields will produce something on the order of five million fewer bbls per day in 2005 than 2004. -5 million per day less in 2006 than 2005, etc. Declining production from existing field is a natural law just like the law of gravity. It cannot be changed or ignored. Every field has a fixed amount of oil and every bbl removed makes future bbls harder to extract. Like squeezing water from a sponge. This means companies must find five mbpd of new production each year just to make up for the loss of production in declining fields and that production loss increases by 5 mbpd each year. Sure there is new production coming online but it is just replacing current production losses.

Regardless of what the arm chair analysts and the talking heads on TV say the end of oil as we know it is rapidly approaching. 2007 has been quoted by the real experts as the probable date where global production begins to decline forever. Recently several of those predictors have moved their target into late 2006. The prices we have now are a result of no material slack in the demand/production equation. Today we produce around 500,000 more bbls than demand about six months of the year. That drops to 200,000 for 3 months and then we are short 200,000 for 3 months in the fall. ANY supply disruption whether from hurricanes, terrorists, refiner problems or just replacement of critical equipment puts us into a negative position very quickly. Emily knocked out nearly 10 million bbls of production in only four days.

For me the answer is crystal clear. Demand will permanently outstrip production soon and life as we know it will change. $5 gas will definitely change the demand factors in the U.S. but not in the rest of the world. Most have been paying the equivalent of $5-$6 per gallon for quite a while and business continues as usual. The need for consumers to drive long distances suddenly diminishes but demand growth continues just at a slower pace. I know this was a lengthy diversion from the regular market commentary but I believe readers need continued justification for buying every dip in oil.

Merrill made a surprising call on Friday when they reiterated a buy rating on CVX, COP, XOM, MRO, OXY and TLM. They said factoring in geopolitics, output stability and demand growth continued to make a bullish case for these stocks even at these levels. Interesting call to reiterate a buy rating at what others feel are overblown prices and a top in the market. Oil companies are starting to report earnings with the majority of the sector due for next week. OXY reported a profit on Friday of $3.78 per share that nearly doubled the $1.46 earned for the same period in 2004. While most oils are expected to post an average of +35% to +37% for the quarter there will be many with even higher numbers. XOM, BP, TOT are expected to report in the +44% to +48% range. STO and NHY are expected to post an +80% gain. Other expectations are COP +40%, MRO +56%, MUR +35% and AHC +13%. Ironically despite these strong earnings and a history of strong earnings many are trading for barely over single digit PE ratios. COP for instance trades at a PE of only 9. They are also valued on the basis of $30 to $35 oil, numbers we are not likely to ever see again.

When I look at the indexes I continue to see them stalling at major resistance. This is what appears to be a perfect shorting opportunity except for one thing. Just like the markets can't break free of current resistance they are resisting every attempt to take them down as well. The Nasdaq touched its high for year at 2191 and was instantly repelled but found support again at 2165. The SPX continues to use 1225 as support and 1233-1235 as resistance. In the case of the SPX the current trading range appears to be narrowing with an upside bias. Of course that oil stock blowout on Friday helped to cause that upside bias.

SPX Chart - Daily

The Dow has the most clearly defined range from 10585 to 10685 and the bias now appears to be slightly negative despite the late afternoon short covering. According to various institutional traders there are quite a few hedge funds currently out of the market. Many of those are trying to get short as Friday's opening suggested. When the dip was bought once again as it has been several times in the last two weeks they panicked and covered again. With markets breaking key technical levels but failing to follow through the mixed signals are very confusing. Hedge funds don't want to commit a lot of money to a direction until it appears and despite the recent gains and new highs the market is still range bound and is giving no evidence of a direction. Were it not for the short covering spurt at Friday's close the combined weekly points for the Dow, Nasdaq, SPX and OEX would have been negative with only the Nasdaq positive by +8 points. The week was very volatile and had numerous high profile events, including earnings from heavyweights INTC, MSFT, EBAY, YHOO, QCOM, GOOG and IBM to name a few. We know earnings are coming in as expected and guidance has been only fair but the markets continue to hold their ground.

I hate to sound like a broken record but the SOX and Russell continue to defy the laws of gravity and are providing an underlying bid to the broader market. The Russell set a new all time closing high but not an intraday high on Friday with a monster buying spike in the last hour. It was definitely a program trade and likely related to short covering before the weekend by funds. Those trying to get short all week ran out of patience ahead of the weekend. It is not wise to be short a dull market over a weekend because anything can happen. Who knows, Osama is still lurking in the background and could be caught when we least expect it. The SOX rallied to close at 475 and only a heartbeat away from monster resistance at 485-490. The SOX did not participate in the end of day rally, which makes be believe even more that the end of day bounce was program trading and possibly funds covering shorts on energy stocks.

SOX Chart - Daily

Russell 2000 Chart - Daily

I had picked this week for a turning point in the market. If it appeared I have not seen it yet. There is every possibility the Thursday highs could be the highs for July but there is no confirmation. Until we get a directional confirmation with a break out of the current range my advice remains the same. I continue to suggest cautious longs over SPX 1225 and shorts under that level. As traders we don't care which direction appears just as long as one eventually appears. My negative bias for the next four weeks is slowly eroding much like the overhead resistance we continue to chip away. I have not been converted to a bull but my fur coat is getting really hot and scratchy on these 100-degree days in Colorado. Fortunately with 1225 as a clear support point it is very easy to follow my own advice. Enter passively and exit aggressively if your direction proves to be wrong.


New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

Editor's note:

We are choosing to wait on adding new plays this weekend. The major averages continue to look overbought and due for a pull back. The DJIA is up more than 450 points from its July low with out much of a correction. The NASDAQ Composite is up more than six percent from its July low without much rest and facing stiff resistance in the 2190-2200 range. The S&P 500 also looks a bit extended from its July low (up 4%). One could say follow the trend, which is up, but seasonal trends need to be considered. The markets tend to peak in the second half of July and head into the traditional Q3 slump to bottom in late September or early October. Right now we'd be more inclined to add bearish plays but the market's recent resilience makes that challenging. We will add new plays to the newsletter on Monday.

New Calls

None today.

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Las Vegas Sands - LVS - close: 40.30 chg: -0.01 stop: 36.99

LVS is a new bullish candidate from our Thursday night newsletter. There is no change from our original play description which we are reposting below.

Adding a new bullish play with the major market averages poised for more profit taking seems rather risky in our book. We find it appropriate that this stock is a casino. Overall the casino stocks have been showing decent relative strength. It is relative strength that draws our attention to LVS. The stock has managed to push to new three-month highs on a day most of the market was trading lower. More importantly LVS has broken through round-number, psychological resistance at the $40.00 mark and technical resistance at its 100-dma and its exponential 200-dma. The P&F chart shows a fresh double-top breakout buy signal that points to a $49.00 target. We are going to suggest calls with LVS above the $40.00 level. Our target will be the $44.50-45.00 range but keep in mind our time frame is pretty short. LVS is due to report earnings on August 3rd and that doesn't give us a lot of time. Any lack of follow through on today's breakout may be a good signal to abandon bullish positions.

Suggested Options:
We are suggesting the August calls since we plan to exit before the August 3rd earnings.

BUY CALL AUG 40.00 LVS-HH OI=2725 current ask $1.80

Picked on July 21 at $ 40.31
Change since picked: - 0.01
Earnings Date 08/03/05 (confirmed)
Average Daily Volume = 934 thousand


Pediatrix Med Group - PDX - cls: 77.91 chg: +0.66 stop: 74.25*new*

This past week has been a decent one for shares of PDX. The stock managed to avoid the sell-off in the healthcare sector. This may have been due to the positive earnings guidance PDX shared with the market on July 19th. We remain bullish on the stock and we continue to target the $80-82 range (FYI: the P&F chart still points to a $92 target). The challenge now is our time frame. We do not want to hold over PDX's earnings report on August 3rd. That gives us about a week and a half. We hesitate to suggest new long positions here but aggressive traders might watch for another dip toward the $76 level as another entry point. We are raising our stop loss to $74.25 near the simple 50-dma.

Suggested Options:
We are not suggesting new plays here. If you choose to buy a dip we like the August strikes since we plan to exit before PDX's early August earnings.

Picked on July 11 at $ 76.10
Change since picked: + 1.81
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 158 thousand


Reynolds American - RAI - close: 83.92 chg: +0.93 stop: 79.99*new*

The rally continues for shares of RAI. The cigarette maker continues to climb and the stock came within one cent of our target on Friday. We will continue to target the $84.00-85.00 range but we strongly suggest that readers consider taking profits here. RAI is looking a little short-term overbought and due for a dip. We are raising our stop loss to $79.99 but more conservative traders may want to put theirs under the $81 level. We are not suggesting new plays at this time. Remember, we only have a couple of days before RAI is due to report earnings. If the stock does not hit our target by Tuesday we will close the play on Tuesday afternoon at the closing bell.

Suggested Options:
This close to our target we are not suggesting new plays.

Picked on July 10 at $ 78.83
Change since picked: + 5.09
Earnings Date 07/27/05 (confirmed)
Average Daily Volume = 664 thousand

Put Updates

Infosys Tech. - INFY - cls: 72.20 chg: +1.77 stop: 75.01

Hmm... our bearish play in Indian software company INFY may not be working out exactly as planned but so far the stock has not strayed from our expectations. On Thursday we warned readers that INFY might bounce into the $72.00-72.50 region and that's exactly what it did on Friday. The gain on Friday is not so much relative strength versus the software sector here in the states. Instead we see it as a reaction to the strong day for the Indian markets on Friday. The Indian stock market surged with a 1.6 percent rally to close at new all-time highs. The rally in the Indian markets may prove to be our biggest risk here with put positions on INFY. Looking at the daily chart for INFY we see the next level of resistance near $74.00, which would be the bottom of its gap down from July 12th. July 12th was when INFY reported earnings. Investors reacted negative as they worried about future growth rates for INFY. The move down two weeks ago helped produce a big double-top pattern with resistance in the $79-80 region. It also produced a reversal on its P&F chart, which now points to a $59 target. Traders can watch for a failed rally under $74 or under $75 as a new bearish entry point. Our target is the $62-60 range.

Suggested Options:
We are suggesting the September puts although the October puts would work well too.

BUY PUT SEP 75.00 IUN-UO OI= 0 current ask $5.30
BUY PUT SEP 70.00 IUN-UN OI=37 current ask $2.80
BUY PUT SEP 65.00 IUN-UM OI=81 current ask $1.25

Picked on July 20 at $ 69.92
Change since picked: + 2.28
Earnings Date 07/12/05 (confirmed)
Average Daily Volume = 922 thousand


Lehman Brothers - LEH - cls: 107.00 chg: +1.87 stop: 108.01

LEH is a new bearish candidate from the Thursday night newsletter. Friday's rebound is certainly a surprise considering the Tuesday-Thursday pattern looked like a bearish reversal. This is a very speculative play and our strategy remains the same so we're reprinting the original play description from Thursday here:

If the new call play in LVS isn't risky enough for you take a look at this put play in LEH. The stock has been a pillar of strength in the market and in its own industry group. Shares of LEH have produced a string of new all-time highs and helped lead the XBD broker-dealer index to its own series of new highs. So why buy puts on a stock that is looking so strong? We believe that LEH is way overdue for some profit taking. The rally in LEH is about nine-weeks old and nothing goes up in a straight line. We want to reiterate that this is a speculative play and carries a higher degree of risk. Our strategy is to try and catch the next bout of profit taking. With the major indices still overbought and looking poised for more weakness we feel odds are leaning toward a consolidation in LEH too. Plus, the action over the last three days looks like a potential bearish reversal pattern. We're basically betting that LEH will pull back toward the $100.00 region before the August $100 puts expire on August 19th. Our official target will be the $100.50-100.00 range. Any dip toward the $100 level should significantly raise the value of the AUG 100 puts currently trading in the $0.50-0.60 range. Our stop loss at $108.01 (above yesterday's high) is superficial. If LEH trades to a new high our puts will probably be close to worthless. More conservative traders may want to pass on this play or wait for LEH to trade under the $105 level first. The biggest challenge we see is the $102.50 level where we expect bulls to try and defend the stock and buy the dip.

Suggested Options:
This is a speculative play on the August 100 puts.

BUY PUT AUG 100.00 LES-TT OI=2220 current ask $0.40

Picked on July 21 at $105.13
Change since picked: + 1.87
Earnings Date 06/14/05 (confirmed)
Average Daily Volume = 2.7 million


3M Co. - MMM - close: 74.71 change: +0.16 stop: 77.51

MMM continues to under perform the market and its peers in the DJIA. There appears to be no catalyst to buy the stock as investors worry over MMM's profit growth. Technically MMM has filled the gap from its late June drop. Plus, MMM continues to trade under the bottom edge of its April-June trading range. The Point & Figure chart is also bearish with a $63 price target. We will suggest put positions at current levels or under the $76 level. More conservative traders may want to wait for a decline under the $74 mark before buying puts. Our initial target is the $70.00-68.00 range.

Suggested Options:
We like the September puts although the October strikes would also work well.

BUY PUT SEP 80.00 MMM-UP OI= 45 current ask $5.90
BUY PUT SEP 75.00 MMM-UO OI=741 current ask $2.25
BUY PUT SEP 70.00 MMM-UN OI=318 current ask $0.55

Picked on July 19 at $ 74.29
Change since picked: + 0.42
Earnings Date 07/18/05 (confirmed)
Average Daily Volume = 3.4 million


Children's Place - PLCE - cls: 46.34 chg: +1.32 stop: 47.51

We cannot know whether Friday's rally in PLCE was short-covering ahead of the weekend of bulls trying to buy a bounce from round-number support at the $45.00 level. PLCE continues to suffer under a five-week trendline of lower highs and we believe it still has new relative lows to set. Our plan is to wait for a breakdown under support at the $45.00 level. A decline under the $45.00 level would produce a new triple-bottom breakdown sell signal on its P&F chart. Our entry point to buy puts is at $44.90. Our target is the $40.50-40.00 range. Traders need to be aware that we plan to exit ahead of PLCE's August 11th (unconfirmed) earnings report.

Suggested Options:

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 08/11/05 (unconfirmed)
Average Daily Volume = 775 thousand

Dropped Calls

Chubb Corp - CB - close: 86.99 change: +0.13 stop: 84.99

We have almost run out of time on this bullish play in CB. The company is due to report earnings on July 26th and we do not want to hold over the event. Per our previous guidelines we are closing the play as of Friday afternoon.

Picked on June 10 at $ 85.05
Change since picked: + 1.94
Earnings Date 07/26/05 (confirmed)
Average Daily Volume = 1.2 million

Dropped Puts

Ishares Global Energy - IXC - cls: 90.31 chg: +1.81 stop: 91.61

It was a volatile day for the IXC but the trend on Friday was pretty clear. Crude oil prices are bouncing and that helped produce a bullish engulfing candlestick pattern on the IXC. The breakout back above the $90.00 level is our cue to exit. Yes, the IXC still has additional resistance in the $91.50-91.60 range but we're not going to sit here and watch the oil sector hit new highs, especially when the oil services sector is surging sharply to new all-time highs. We're choosing to close the play early to minimize any losses.

Picked on July 14 at $ 89.15
Change since picked: + 1.16
Earnings Date 00/00/00
Average Daily Volume = 33 thousand

Trader's Corner

Fair Is Fair, or Is It?

Each morning, CNBC commentators note whether futures weigh in above or below fair value. What is fair value as it applies to the indices, anyway, and why does it appear to be such a confusing topic? According to H.L. Camp and Company, more callers to CNBC's Squawk Box ask about fair value than any other topic. The term doesn't hold the same meaning for all, it turns out, and some would argue that the CNBC-type accounting of fair value proves to be a sloppy and useless measure. An article written by Mark Hanes and contributed first to CNBC.com and then reprinted on another source argues against that conclusion.

Most CNBC watchers want to know each morning whether S&P 500, Nasdaq and Dow futures are trading above or below fair value. They want an idea of how sentiment lies as the open approaches. If futures trade above fair value, they feel that early trading might have an upward bias. If futures trade below fair value, they prepare for early trading with a negative bias. Wise traders don't expect that bias to always appear or to carry much beyond the opening moments, however, with other factors then kicking in to contribute to the behavior of the markets.

The CNBC version of fair value differs from the strictest interpretation of that term, according to some sources. According to Investopedia, the CNBC-type meaning references the difference between the actual cash value of an index and the futures contract on that index. More specifically, Herb Greenberg, Senior Columnist for TheStreet.com defined the CNBC-type term as the difference between the closing cost of the component stocks of an index the day before and the closing cost of the futures contract.

That definition of fair value will garner complaints from purists, however, as it did for Herb Greenberg back in 1998 when he briefly answered a reader's question about fair value. One correspondent wanted to redefine that "CNBC-type" fair value, as many sources tagged it, as the "the closing spread," a different value entirely from the more respected "fair value" meaning. Greenberg's next column was comprised of a number of excerpts from readers who wanted to expound upon or argue against Greenberg's brief answer, but none contested Greenberg's characterization of CNBC's use of fair value. Hanes' definition, however, comports with the more traditional definition of fair value, as it turns out.

Investopedia, brief as its definitions tend to be, offers a more analytical computation for this equilibrium price or fair value for a futures contract, different from its "CNBC type" definition. This site notes that fair value is calculated by figuring in spot price, compounded interest paid and dividends lost until the expiration of a futures contract. Futures owners do not collect dividends, as do owners of the actual stocks.

Index arbitrage traders may be more interested in that traditional computation than in a closing spread. Here's how it works. If futures are priced at fair value, then they're theoretically at the same value that cash indices are in the absence of transaction costs. To calculate fair value, financing charges, a function of interest rates, would be added to the spot prices, and dividends would be subtracted to account for those transactions costs. The Chicago Mercantile Exchange's Rule 813.D sets forth the calculation and rules for fair value. HL Camp & Company uses the following formula:

FV = S[1 + (I - D)], where "FV" is fair value, "I" is the interest a trader would pay to borrow enough money to buy all the SPX stocks, and "D" is the dividend that would have been collected if the stocks had been owned instead of futures.

There's a time factor applied to the calculation of the interest, as the interest must be calculated from the date of the FV calculation until the expiration of March, June, September or December expiration of a futures contract. Carrying costs will drop as a futures contract draws nearer to its settlement day, so the fair value will more closely approach the actual spot price of the index in question. Those interested in following an exact computation of fair value, an exercise that might be useful for all to follow at least once, can find such a sample computation at www.cme.com/trading/prd/equity/fairvalue2543.html on the Chicago Mercantile site. Following such a computation provides a greater grasp of how fair value might change as interest rates or dividends change.

Hanes' article makes note of the same computations in the CNBC's version of fair value. At the time his article was written, CNBC was receiving fair values from Prudential Securities, and Hanes noted that the formula used was as follows:

F = S[1 + (I-D)t/365], where F is the fair value for futures; S, the spot index price; I, the interest rate, expressed as a money market yield; D, the dividend rate, expressed as a money market yield; and t, the number of days from the spot value date until the settlement of the futures contract. That formula argues against detractors who claim that the "CNBC type" fair value is a less useful measure of closing spread.

Useful or less useful to index arbitragers, that is, although many everyday traders might be interested in the times when futures and index values get so out of synch that program buying or selling programs are likely to be triggered. For that reason, the discussion of fair value probably wouldn't be complete without a discussion of premium. One of Greenberg's correspondents described premium as a threshold amount above or below fair value, at which buy or sell programs might be triggered.

If futures contracts are trading at fair value, big funds or institutions don't care whether they own stocks or futures. Arbitrageurs aren't going to find an opportunity to exploit the difference. If futures are trading at a threshold amount above fair value--if it would cost a threshold amount more to buy and hold futures until their settlement than to buy the equities and pay the transactions costs until that settlement day--then futures contracts might be sold and equities bought. If equities are trading at a threshold amount above futures, arbitrageurs might take the opposite action. HL Camp and Company claims that index arbitrage actions currently account for only about 10 percent of all program trading activity, however.

For those interested in watching for program trading activity, premium value should also be understood. Premium values are spreads that measure the arithmetic difference between futures and spot index values. So there's that plain old spread showing up again, rather than the more complicated formulas for fair value. Hanes says that CNBC defines "premium" just as it's defined here. Premium value can be monitored on many charting or quote services. Traders should check the symbol help section on their services to find the appropriate levels.

So how is that spread or premium used on CNBC or elsewhere? HL Camp & Company provides program selling levels each day for those traders interested in setting alerts for potential program selling or buying signals. On our site, Jeff Bailey usually provides those numbers for the benefit of readers who want to watch or set alerts. For example, on Friday, July 15, the company's fair value for the S&P 500 was set for +$3.57, with their computers set for program buying at +$4.71. The same day, another service listed fair value at +$3.52 and suggested that traders buy the SPY if the premium rose above +$4.85, so obviously the various companies issuing these program trading signals might offer slightly different results.

While these sources include premium, as defined as that spread, in their decisions as to where program buying or selling might occur, they do not use premium alone. Rather, they include proprietary studies on where program selling is most likely to occur with respect to the fair value and the premium of the futures to the cash index. They're making proprietary guesses, if computer-assisted and sophisticated ones, as to the probability that a buy or sell program would be triggered at a certain premium level. Hanes' article indicates one reason that some buy or sell programs might not be triggered when expected and why those proprietary studies might be needed. Because arbitrageurs use borrowed money and since each might have a slightly different interest rate, not all arbitrageurs might act at the same premium level.

HL Camp and Company describes premium as the spread between the most active of the available S&P 500 futures contract, usually the front-month contract, and the actual cash index value, with the cash index value subtracted from the futures contract. Most times, the spread varies between +/-$5.00, the site notes. This company's numbers are projections for the amounts at which they believe program trading will kick in and index stocks might be bought or sold as a result. The company corroborates that premium values cannot be used as a pure indicator of when a buy or sell program might kick in, as the company's extensive research has shown some occasions when PREM signaled that a buy or sell program should occur but didn't.

Some traders find it helpful to monitor premium values and match that to a preferred source's projections of when buy or sell programs might be hit, to gauge their own buy or sell decisions on these best guesses. However, as Hanes himself cautioned, the action of buying stocks when futures are a certain threshold above fair value helps to narrow that spread. That action brings futures closer to fair value. The narrowing can happen quickly, as it can when futures might have been at a discount to the indices, and equity selling occurs. Those who have seen pre-cash-market futures values far above or below fair value are often surprised to see action at the open. That upward or downward bias sometimes doesn't last long, sometimes not even until the cash open. Use those comparisons as one tool only.

If Hanes' characterization is correct, it turns out that those who disparage "CNBC type" fair value might need to be a little fairer in their criticisms, but let's look at actual numbers. On the morning of July 21, CNBC noted that fair value for the SPX was +$2.05. The SPX close the day before had been 1235.03 while futures saw a 4:00 closing value of 1236.75, a 3:15 value of 1237.50 and a 5:15 closing value of 1236.25, none of which translated into a closing spread of +2.05. However, HL Camp & Company noted more traditional calculation of fair value at +2.08 for the day, roughly analogous to the CBNC-announced version. It appears Hanes was right. Early in the morning, futures had been positive, but below fair value, indicating that expectations were for a flat or slightly lower open, but the Chinese announcement about the unpegging of yuan and the news of new bombing attempts in London changed the outlook, with equity futures shooting all directions. Fair value comparisons probably proved less useful than other factors.

This article was intended to provide an overview of these often-confused terms rather than to promote a trading style based on potential program selling or buying points. Some find such tactics useful; others, less so. Traders should monitor premium and expected buy or sell programs for a time to determine applicability to their trading styles before basing decisions on those signals.

Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.


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