S&P futures, fair value, & program trading

Originally posted by vulture
Think for a minute about an arb executed as contracts rolled over in 1998-2000 when you had a 15-25pt premium in the futures to the cash that would eventually erode to 0 over three months. Now that same spread is somewhere in the vicinity of 2-3 points for the same duration...

I have noticed that decline in the PREM over the past 3 years and am just drawing my own conclusions and assumptions. Someone might have some better information about the implications of this decline...
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Your assumptions are pretty accurate. The decline in the premium is attributable to several factors. You already touched on the interest rates (cost of carry). Another very big factor is the actual price of the indices themselves. As the prices decrease, the premium will be less just because anticipated moves tend to be smaller in hard numbers (not percentage). A third factor is dividends. This part of the equation is not as clear to me without looking it up. I don't know if the dividends from the S&P 500 have actually decreased. So I can't state for sure this is a factor. But the plain vanilla real factors have decreased.

Just like in options, the value of futures is based on time X cost of carry, and dividends. And of course the wildcard is volatility. Seems like we have plenty of that. But we have for quite a while.

But still, I too wonder why the decrease is so substantial. We still have a way to go until Sept. expiration, and the fair value does seem inordinately small even given the above mentioned factors. I will find out however and keep you posted. Also, anyone looking at CNBC's fair value on their tape; their values are just wrong! Pay no attention to those numbers. I saw them showing a negative number this past week as "fair value"....wish I could trade against THEM:)
 
Originally posted by EricP
Not sure how so many knowledgeable people can have such differing views on what the Premium is, or how it is calculated. The only explanation I can imagine is that different people use this term in different ways, as it applies to the futures and cash markets.

As I mentioned in an earlier post, I support vikana's definition of the Premium, in which the Premium is totally unrelated to the Fair value. Instead, the Premium is merely the result of subtracting the current cash index quote from the futures price:

PREM = Futures Index quote - Cash Index quote

I offer the following links to support this definition (the first two relevent links on a Google search):

http://www.elitetrader.com/tr/index.cfm?s=15&t=70
<i>"The absolute difference, in points, between the S&P futures and the cash index has come to be referred to as "the premium," regardless of whether the number is positive or negative."</i>

and
http://ids.csom.umn.edu/faculty/kauffman/courses/8420s98/Project/Programmed_Trading/Example.htm
<i>"To find out if the market is fairly valued at the present time, simply subtract the S&P 500 cash index from the S&P 500 futures price. The resulting number is known as the Premium."</i>

In any case, from the discussion (Don's last post) it appears that the term Premium is also used by some traders to be NET of fair value. In other words, at what level are the futures trading above or below the expected fair value premium. Although I have never personally heard of the Premium term being used in this fashion, it appears that this is another variation that some traders use for the term Premium.

It doesn't really matter what definition you use, so long as you understand what this definition means, and how to use it, and how it is defined by your quote vendor. I'd be interested to hear if anyone knows of a quote vendor that defines their PREM in the way that Don and steve uses it. Could be confusing if various vendors define it in different ways.

-Eric
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This happens a lot...."definition" differences. Like in options, some people (including Series 7 test), call the price of an option "the premium"....when traders refer to "premium" as the amount over FV.

We try to make the concept clear, and simply use PREM./DISC as the difference between where the S&P's "should " be trading vs. their actual price.

Don
 
regardless of whatever it is called, the difference between the cash and the futures tick by tick during the trading day is always the correct value at that moment in time - otherwise it would not occur

it is the change of the value against the prior values during the course of trading day which provides information which can be traded off

trading against that value - except with computerised arbitrage could damage your wallet
 
Originally posted by stevet
regardless of whatever it is called, the difference between the cash and the futures tick by tick during the trading day is always the correct value at that moment in time - otherwise it would not occur

it is the change of the value against the prior values during the course of trading day which provides information which can be traded off

trading against that value - except with computerised arbitrage could damage your wallet
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OK...not disagreeing with you , but for the sake of those who are still confused about the concept of Premium/Discount to FV, let me try this:

The spot price plus "cost of carry" (Interest) is what Fair Value really is. Today about 80 cents over the spot. If the futures trade at 80 cents over the spot price (approximately) then they are trading "at fair value." If they are trading above that, then they are trading at a "Premium" and if they are trading below that, they are trading at a 'Discount."

We look at that Prem/Disc all day long to see if we have an immediate bias in either direction. The futures traders on the floor will be buying stocks to hedge their short futures when they can sell them (the futures) at a premium to FV. They will be selling stocks when they can buy futures under FV.

Hope this helps others .....

Don
 
Don Bright

absolutly, and if i was in the pit - i would be doing the same thing and loving it

its a bit more dicey when you do not have the latest up to the moment data - which u can only get in the pit

or you have been doing it for so long that you know how to spot the tradeable ones

or you have a computerised arbitrage system
 
don

the floor of a few bars - but not the pit - not even that much trading of any sort as it happens

and you are the first person not to tell me i am wrong - i guess i owe u a drink now
 
Originally posted by Don Bright




The spot price plus "cost of carry" (Interest) is what Fair Value really is.
Don
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Don, someone asked about this and my response was the pretty much the same as yours, plus I mentioned dividends are factored in.
The person asked why the fair value premium seemed lower lately. In my explanation, I got into the hard prices of the underlying securities being lower, and so the cost of carry would be lower due to this and also to the fact that interest rates are lower now. But what about dividends? Have they actually diminished over the past few years? I have not really been aware of too many dividend cuts, but I am not sure. Do you know if this is a factor?
Thanks,
RS7
 
Originally posted by rs7

Don, someone asked about this and my response was the pretty much the same as yours, plus I mentioned dividends are factored in.
The person asked why the fair value premium seemed lower lately. In my explanation, I got into the hard prices of the underlying securities being lower, and so the cost of carry would be lower due to this and also to the fact that interest rates are lower now. But what about dividends? Have they actually diminished over the past few years? I have not really been aware of too many dividend cuts, but I am not sure. Do you know if this is a factor?
Thanks,
RS7
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Lower or cancelled dividends, lower interest rates, lower stock prices all add up to lower overall number in FV calculations. Yep, that's pretty much it.

Don
 
Originally posted by stevet
don

the floor of a few bars - but not the pit - not even that much trading of any sort as it happens

and you are the first person not to tell me i am wrong - i guess i owe u a drink now
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Just "sparkling water" these days!! Thanks...

Don
 
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