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Trader's Corner

Who's the Fairest of Them All?

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These days, everyone wants to know where the equity markets are going. Is the outlook at ugly as it has been?

Equity traders turn on CNBC before they have their first cups of coffee. If futures are higher, bulls preen in this mirror that they believe gives a glimpse of the earliest trades, although they haven't been doing much preening of late, unfortunately. If futures are lower, bears are the ones preening in front of that mirror.

Both bulls and bears could be looking at distorted images, though, unless they're also looking at fair values. Turns out, the mirror can lie. Of course, on days like Friday, when the SPX futures were down in the range of 15-25 points, depending on when one first glanced at the television screen or computer monitor, they weren't telling lies. The SPX was going to decline at the open. However, if the S&P 500 futures were down by two points, but the fair value for that index was lower by five, then futures are stronger--prettier, if you want to stretch the mirror analogy--than fair value. The SPX may be moving higher during the earliest trading, not lower.

I'm reprising a previous article on fair value for the benefit of new subscribers or for those who might have forgotten the definitions. They're easy to forget. Just as beauty is in the eye of the beholder, so is "fair" when it's applied to fair value.

If you're not quite sure about what the terms means, you're not alone. According to H.L. Camp and Company in a statement made several years ago, more callers to CNBC's Squawk Box asked about fair value than any other topic. Some people wouldn't approach CNBC for a definition, perhaps unfairly believing that the CNBC version of fair value differs from the strictest interpretation of that term.

So, let's get to definitions. 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 several years ago defined the CNBC-type term as the difference between the closing price of each of the component stocks of an index and the closing price of the futures contract.

That type of fair-value calculation, whether or not CNBC employs it, will garner complaints from purists, however. It did for Herb Greenberg back in 1998 when he briefly answered a reader's question about fair value. One correspondent to his column 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.

Maybe they should have contested that unfair characterization. An article written by Mark Hanes and contributed first to CNBC.com and then reprinted on another source comports with the more traditional definition of fair value, as it turns out. So, let's get to that one.

Investopedia offers another definition in addition to the "CNBC type" one. That second definition 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 http://www.cme.com/trading/prd/equity/fairvalue.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. When I first researched this article several years ago, HL Camp and Company claimed that index arbitrage actions then accounted for only about 10 percent of all program trading activity, however, and I read recently that advances in electronic trading has further diminished opportunities for arbitrage trades. I can't verify that as being true, 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. The various companies issuing these program trading signals might offer slightly different results because they're the ones calculating what they think that threshold level will be.

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. My recent reading, since this material on fair value and premium was first presented, suggests that the narrowing occurs faster now than it previously did in this age of electronic trading.

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.

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.
 

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