The Idiot's Guide to Premium and Fair Value

Discussion in 'Technical Analysis' started by rs7, Apr 16, 2003.

  1. rs7


    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?).. 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" 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)
  2. rs7


    OK, most of us do not have the resources to take advantage of the disparities in "premium"...we can't buy or sell all 500 S&P stocks, and we, for the most part, are not sufficiently funded to trade the big S&P contracts. Plus, unlike Merrill Lynch, Goldman Sachs, and the other big boys, including the Mormon Church (yep..the Mormon Church), we have to pay commissions. They are members of the exchanges, and they don't pay commissions. And their trading platforms are better than ours....they have people in the pits, we don't.

    So how can we benefit from knowing all this? Well, in theory, if you see the premium expand to $4 or $5 dollars, you will immediately see stocks zoom up. So do you buy when you see this big premium? Not a good idea. You will be too late by the time you get filled. And also, remember, the institutions that just bought stocks in their "program" will be looking to sell and get flat. So if you are to use "premium" to make a trading decision, you want to determine if a spike in prices was caused by a program. Now you know what to look for. How to take advantage? That depends on your style. For me, I will try and short a stock with relative weakness on the day that spiked on a buy program. Usually a Dow stock.....liquid, and more representative of the S&P than average. Conversely, after a "sell program" I will look to buy one of the strong stocks that took a quick dive. Again, Dow stocks seem to make the most sense.

    Can we do this kind of arbitrage as individuals? I have a friend that has been amazingly consistent trading the "premium" he has determined between the QQQ's and the NQ mini contracts. And the SPY's against the E-mini contracts (I don't know his exact ratios, and how he figures his "premium"). I only know that he is THE MOST PATIENT TRADER I have ever known. He is at his desk form bell to bell every day, and may only make several trades a month. Better to be right a few times than to hope to be right a lot of times, and know you will be wrong a lot of times as well. He is seldom wrong.

    Now, while institutions can afford to wait for the premium to come back into line, sometimes this takes a while. So my friend has a "pain threshold".....he calls it his "uncle point"....we all have our own ways to stop out. So his method works phenomenally well, but is not foolproof. So maybe I should add the usual disclaimer...."don't try this at home!"

    Well, maybe I said too much, and maybe not enough. Depends on where your knowledge base was when you first started reading this. I KNOW this is too simple for many of you, and maybe a bit much to absorb for some really new traders.

    For them, think of it this way. If you could buy a crate of apples in New York for one price, and know you could sell them at a "premium" of $2 per crate in Chicago, and that would cover your would not do it.. not to break even. Your cost is $2 to get the apples to Chicago. But if you knew you could get $4 more in Chicago, you would, if your cost remained at $2 to get them there. Same principal as trading stocks in NY against futures in Chicago.

    Hope this has been a coherent explanation. And anyone who has anything to add, I welcome you to contribute. And questions? I will do my best. I have traded these techniques, and they do work....but I was working for a member firm with seats on all the exchanges. I myself have not tried this "at home" (but I am thinking about it!!! Who wants to back me? :) )

  3. rs7


    How come nobody voted in the poll? What does Candle have that I don't? :) :) :)

    Good Pesach, and Happy Easter. And a great loooong weekend to all.

    Rs7 will be in the hospital on Monday, but back strong on Tuesday...

    Trading tomorrow? Jury still out. Maybe a day off to make it a 5 day weekend...


  4. Could you repeat that please?

  5. andy4


    well appreciated,

    Thank you

  6. ditto. Thanks in adv, Rs.

    One thing that I don't have is fair value for individual stocks, since none of my data feeds support it. If you could throw in a bit about how to do that calculation manually for an individual stock, say GE for example, I'd be grateful.
  7. nice work, thank you.

  8. THANKS RS7. this idiot finally understands premium. well said.... the idiots guide............!
  9. rs7


    Wow, my most esteemed Brother Bung....couldn't you have come up with a more exotic question?

    I don't understand exactly what you are looking for. Do you mean as fair value relative to SSFs? Or against a tracking stock like the DIAs? or SPYs?

    My head is spinning from the confusion! (is this what Dubya feels like all the time?) (uh oh, hope the righties don't get offended)

    Anyway, I will give this some thought when the passover wine wears off!

  10. garbo



    I just voted in the poll and you should be receiving some funds soon. You do take PayPal? :p

    Also: Could you provide an Idiot's Guide to the Bond Basis? How about the hedging T-Bonds and T-Bills with ZB and ZN? I'm sure others besides myself might appreciate that.
    #10     Apr 16, 2003