As a tribute to Brother Candle, I have decided to include a poll
(an afterthought upon proof reading this long boring diatribe)
About a week or so ago, I made a statement something to the effect that premium and fair value seemed to me, from many of the discussions here, to be both misunderstood, and made into a more complicated issue than it is.
Since I made that statement, along with the promise to give a simple explanation, I have been inundated with private messages.
So here I will give, what to me, is an oversimplified but hopefully easily understood explanation of what premium, and fair value are, and how they apply to daytrading. I apologize in advance to those many here that may have a better grasp of this than I do. But for those who don't:
FAIR VALUE is the pre-determined amount of dollars above (or below) the cash S&P 500 index that the S&P 500 futures contract should be trading. This is determined by a number of factors, including time value (think options), cost of carry (interest rates) and dividends. These values are computed by people far more knowledgeable than most of us....who of us really knows what every ex-dividend date and value of those dividends of the basket of 500 stocks is? (for example)....not to mention the cost of carry, the calculation of "lost" income by not being in interest bearing accounts, time value (anyone here capable of doing Black Scholes or Cox-Ross in their heads?)..
OK...so now we have a theoretical "Fair Value". And for simplicity sake, let us assume that this number is $2 today. So, if everything goes to plan, the futures will be trading $2 higher than the cash index (SPX). Today...tomorrow will be one day closer to expiration of the futures, and that will change the number slightly.
Now I have not used any quote providers other than Reuters (Quotron) for many years, and a long time ago, I used Bridge and Bunker Ramo (whatever happened to them?). Whatever quote service any of you use, I am sure that there is a way to "program" this "spread" or "premium".....very simple: Futures minus Cash. So for example, on Reuters, I put in SPM.Z which is the symbol for June futures, minus SPX which is cash. So my formula looks like this: (SPU.Z-SPX)...what could be more simple? But even if your feed provider does not allow formulas, just eyeballing these two numbers will easily tell you if the number is above or below our hypothetical $2.
Now we go to our sources on the internet (find your own...there are many) and we see (again, hypothetically) that a spread, or "premium" of $3 or more will trigger a "buy program" and a premium of $1 or less will trigger a "sell program".
Well what does this really mean? Let us assume you are Merrill Lynch, or J.P. Morgan, and you had unlimited resources, and you could buy and sell S&P contracts, and all 500 stocks in the index to your heart's delight. (Although one contract, and one basket of the 500 stocks is quite adequate).
To keep things simple, lets say the cash index is at 1000. That means the futures should trade at 1002. But all of a sudden, the futures are at 1004. Now the premium, which should be at $2, is at $4. So....we sell the futures, and buy the cash. We really are not concerned with the price, just the difference in price. Doesn't matter if the underlying stocks go up or down. Why? Because we sold for $4 above "fair value" and that is our "credit"....And the only thing we need to do is wait for the premium to come back in line with "normal"...in this case, $2. At that time, we buy the futures to close the position, and sell the stocks, to close that position. And we have a profit of $2.
Why does it not matter if the stocks go up or down? This I can leave you all to figure out for yourselves. And if the "premium" goes to, let's say, 50 cents, then we BUY the futures, and SELL the stocks. Same thing as our "buy program" except it's the mirror image. We will still close the position at the $2 "fair value" premium. (in a sell program, we start with a debit rather than a credit).
Why do they call it "program trading"? Because it is done by computers that are "programmed" to make these trades. And even computers get screwed on fills like we do, so this too is figured in to the amount of premium that will trigger these programs.
Now, what does all this mean to us as traders?
(going to continue on next page so I don't exceed the word limit)
(an afterthought upon proof reading this long boring diatribe)About a week or so ago, I made a statement something to the effect that premium and fair value seemed to me, from many of the discussions here, to be both misunderstood, and made into a more complicated issue than it is.
Since I made that statement, along with the promise to give a simple explanation, I have been inundated with private messages.
So here I will give, what to me, is an oversimplified but hopefully easily understood explanation of what premium, and fair value are, and how they apply to daytrading. I apologize in advance to those many here that may have a better grasp of this than I do. But for those who don't:
FAIR VALUE is the pre-determined amount of dollars above (or below) the cash S&P 500 index that the S&P 500 futures contract should be trading. This is determined by a number of factors, including time value (think options), cost of carry (interest rates) and dividends. These values are computed by people far more knowledgeable than most of us....who of us really knows what every ex-dividend date and value of those dividends of the basket of 500 stocks is? (for example)....not to mention the cost of carry, the calculation of "lost" income by not being in interest bearing accounts, time value (anyone here capable of doing Black Scholes or Cox-Ross in their heads?)..
OK...so now we have a theoretical "Fair Value". And for simplicity sake, let us assume that this number is $2 today. So, if everything goes to plan, the futures will be trading $2 higher than the cash index (SPX). Today...tomorrow will be one day closer to expiration of the futures, and that will change the number slightly.
Now I have not used any quote providers other than Reuters (Quotron) for many years, and a long time ago, I used Bridge and Bunker Ramo (whatever happened to them?). Whatever quote service any of you use, I am sure that there is a way to "program" this "spread" or "premium".....very simple: Futures minus Cash. So for example, on Reuters, I put in SPM.Z which is the symbol for June futures, minus SPX which is cash. So my formula looks like this: (SPU.Z-SPX)...what could be more simple? But even if your feed provider does not allow formulas, just eyeballing these two numbers will easily tell you if the number is above or below our hypothetical $2.
Now we go to our sources on the internet (find your own...there are many) and we see (again, hypothetically) that a spread, or "premium" of $3 or more will trigger a "buy program" and a premium of $1 or less will trigger a "sell program".
Well what does this really mean? Let us assume you are Merrill Lynch, or J.P. Morgan, and you had unlimited resources, and you could buy and sell S&P contracts, and all 500 stocks in the index to your heart's delight. (Although one contract, and one basket of the 500 stocks is quite adequate).
To keep things simple, lets say the cash index is at 1000. That means the futures should trade at 1002. But all of a sudden, the futures are at 1004. Now the premium, which should be at $2, is at $4. So....we sell the futures, and buy the cash. We really are not concerned with the price, just the difference in price. Doesn't matter if the underlying stocks go up or down. Why? Because we sold for $4 above "fair value" and that is our "credit"....And the only thing we need to do is wait for the premium to come back in line with "normal"...in this case, $2. At that time, we buy the futures to close the position, and sell the stocks, to close that position. And we have a profit of $2.
Why does it not matter if the stocks go up or down? This I can leave you all to figure out for yourselves. And if the "premium" goes to, let's say, 50 cents, then we BUY the futures, and SELL the stocks. Same thing as our "buy program" except it's the mirror image. We will still close the position at the $2 "fair value" premium. (in a sell program, we start with a debit rather than a credit).
Why do they call it "program trading"? Because it is done by computers that are "programmed" to make these trades. And even computers get screwed on fills like we do, so this too is figured in to the amount of premium that will trigger these programs.
Now, what does all this mean to us as traders?
(going to continue on next page so I don't exceed the word limit)
