Fair value is not a fail safe, doesn’t always tell you where things are going to open, and becomes useless just minutes into the day.
Every morning, if you flip on a financial TV station, or sometimes just listen to the morning radio, you’ll often hear them talk about the DOW or the S&P futures. Then they wiggle in another little tid-bit, they mention “fair value”. What is it? What’s it do? Why is it there? Does it matter?
If you already know, then this little tutorial is worthless, and you should go mow the lawn or something. But if you don’t, then read on and maybe you’ll find a little nugget that helps you out.
First off, we have to look at two separate things. The “cash” market, and the futures market. The cash market is easy to see, you see it every day. You glance at CNBC or FOX and see “the DOW is trading at 25,700” or some such number. Well that’s the collective total of the value of the stocks.
Charles Dow, the cofounder of Dow, Jones & Company, created the index in 1896 to track the prices of a dozen industrial stocks. To calculate the index, he simply added up the prices of the stocks and divided them by 12.
The index has since been expanded and now covers 30 supposed blue-chip stocks in a wide range of industries; the calculation has also evolved so as to account for stock splits, spinoffs, and other events. Even so, the Dow is still based on the stock prices of its constituents. Again it doesn’t match exactly, because of splits, etc, but the baseline is indeed the price of individual stocks.
That’s called the cash market. Okay, so what’s a future? The best way to understand how stock futures work is to think about them in terms of something tangible. Let's say you own an orange juice company and you need to buy oranges to make your product. Every business day, the price of oranges goes up and down. You want to buy oranges for the lowest price possible so you can make the most profit when you sell your juice. But you realize that the price of an orange today might be very different than it is a year from now. So you enter into a futures contract with a farmer to buy his oranges at a specific price on a certain future date.
The farmer needs to make money, too, so he's not going to agree on a price that's way below the current market value. So you'll agree to a fair price to ensure that both of you will be happy with the transaction in a year. It won't be the highest or the lowest price, but neither one of you will get pounded by drastic market, or weather fluctuations.
Stock (and to most extent index) futures work in much the same way. Two parties enter into a contract to buy or sell a specific amount of stock for a certain price on a set future date. The difference between stock futures and tangible commodities like Oranges, wheat, corn, and pork bellies -- the underside of the pig that's used to make bacon -- is that stock future contracts are almost never held to expiration date.
The difference between stock futures and index futures such as the DOW or S&P is simply that 1) in a stock future, you’re talking about one individual stock, while with an index future, you’re talking about the whole index, and 2) while most all futures settle in cash payments, you “can” take delivery of a single stock via your future, where as it’s nearly impossible to deliver an index of stocks.
Basically everything settles in cash, win or lose.
Okay, so what the heck is this fair value gizmo? Well, it’s sort of complicated, but if you think about it, not really. If you decided to buy 1 share of every stock on the DOW right now, it would be pretty easy to determine how much money you’d need. You’d simply add up the current price of all 30 stocks and hand over a check for the total.
But when you’re wagering in the futures market, you’re making your “bet” based on a time and a price IN THE FUTURE. Okay, no big deal yet, right? Right. Except we have to factor in some things. First off, between now and the futures expiration date ( which could be almost 3 months out) a lot has to be taken into consideration. For instance, are there dividends being distributed during that period? Well if you own the futures contract instead of the stocks, you do NOT get those dividends. That has to be factored into the equation.
Likewise the carry cost of interest rates. Suppose you wanted to buy every stock in the S&P. Unless you’re Bill Gates, you’d be borrowing the money to do that. Well, you’d have to factor in the idea of borrowing costs to do that ( interest rate payments)
So, determining the Fair value relationship between the S&P 500 futures contract and the underlying S&P 500 cash index requires adding the cost of borrowing the money to buy the S&P stocks while subtracting the gain those stocks pay in dividends. They rarely match up.
So every evening just after the market close, the financial institutions do the math and assign either a plus or a minus to the futures. For instance if tomorrow ahead of the open, they determine that fair value is +5 points, it means the futures price should be 5 points higher than the cash close the day before.
At the beginning of the trading day, you can often ( but not always) use the fair value to predict if the open is going to be higher or lower. For instance if the S&P fair value were + 7, chances that morning are good that the S&P is going to rise some at the open that day. Vice-versa if the fair value is -11, the likely hood is that you’re going to see the cash market open lower.
I think where some folks get a bit confused is this: They see the “futures” trading at say +100 on the DOW, but when the market opens, it only gains say 50 points. Why is that? Well, maybe because while the futures were up 100, “fair value” on those futures might have been – 50. So when the bell rang, the arb’s quickly closed that discrepancy, and sure enough the cash market quickly lined things up with the futures as figured WITH fair value included.
Likewise, you could wake up one morning, and see the futures down 100 and think “wow, we’re going to have a rocky start”, only to see the opening bell ring and we open “unchanged” or maybe up or down a handful. Why? Maybe while the futures indicated -100, what if fair value was -80 or 90 or even 100? The market would be opening “at” fair value. ( or close to it)
Fair value is not a fail safe, doesn’t always tell you where things are going to open, and becomes useless just minutes into the day. But for the most part you can tell if you’re going to be green or red at the open, by watching where the futures are, and where fair value is. I hope this helped.