Q&A
Since You Asked
| Professional trader Don Bright of Bright Trading, an equity trading corporation, answers a few of your questions. | 
Don Bright of Bright Trading |
PREMIUM AND FAIR VALUE
Congratulations on your articles in S&C: the pages I always read
first! They're pithy, honest (that's a welcome change), and highly informative.
I am a private trader and have been trading the S&P only, intraday,
for the past few years. I have been searching for information on how to
use the premium and fair value for a long time, so your mention of H.L.
Camp was a real bonus. I would have signed up for his seminars instantly,
but my doc won't allow me to fly (and I use CQG, which doesn't meet with
his approval either!). Can you kindly tell me if there is any book, article,
or other method of learning how to use these tools efficiently? I do not
use any proprietary software; just the basic tools provided within CQG,
and I take no daily or weekly tip sheets. As you say,"The best system
is the human brain, when properly trained." Do it yourself! And it
cost me a few thousand dollars to learn that obvious truth! My sincere
thanks. -Ian Robertson
Thank you for your kind words! I certainly do not want you to go against the orders of your doctor, whether they relate to travel or trading. I am a fan of"true" education, and not a fan of hype as it relates to one system over another. I have pointed out the H.L. Camp website before, and use their fair value calculations almost daily (although the calculations are available elsewhere on the web). I have not been to their seminar, but would guess they are informative, based on what I have read. I am aware of CQG as a data vendor, but have not spent any time with their platform, so I will address your question as it relates to concept only.
The "fair value" of the S&P 500, or any other tradable commodity, is determined by "cost of carry," which is essentially cost (of index) plus interest rate/time minus dividends that would be received if you owned the actual stocks. Which means that if you had to buy all 500 stocks and carry them for the specified time period, it would cost you the interest money paid to your broker. The dividend amounts actually cause the fair value number to move independently of the automatic rate of time decay (for cost of carry). Simply put, the S&P future is worth a premium over the actual spot or cash price of the S&P 500 (SPX or INX on most quote systems), since you don't have to outlay all the cash to buy the underlying securities while still benefiting from movement.
When the traders on the Chicago Mercantile Exchange (CME) are able to sell futures at a premium over fair value, they may decide to hedge themselves by buying the actual stocks. When they can buy the futures at a discount to fair value, they may be inclined to sell back the stocks. This is also done via "program trading" using various methods by trading firms off the trading floor.
As equity traders, we like to know if the futures are trading at a premium or discount to fair value before entering or exiting a trade. This is a major part of a larger decision-making process that most professional traders use. I personally like to keep a small window next to my S&P tick chart that shows me the premium or discount.
We, of course, use fair value premium or discount to determine pricing
for our opening only and other similar strategies. You can go to www.cme.com
to view the education available from the Mercantile Exchange. I hope this
helps.
DERIVATIVES VS. SELLING SHORT
I've read you prefer to use derivatives instead of selling short. Would
you please explain the reasons for that? I prefer selling short, as it
is less risky while getting experience in market reading. -Guntars Bernhards
Good question! First, let me explain: Selling short requires marking your order as a short sale, which requires an uptick for your order to be completed. (Going short means that you make money on the downside move of a stock without necessarily selling short.)
Now, let me explain it this way. To be filled on a short sale, someone must buy the stock from you on an uptick, which by definition means that there is an upward bias at that moment. You won't see anyone buying on upticks (a price higher than the last sale) when the market is crashing. A good trader will not want to counter the upward bias by selling short. Now, when the market is spiraling downward and you want to profit from this move, you must be able to hit bids (sell stock at the bid price, which is generally not an uptick), which means you must have long stock to sell. By using derivatives (options), professional traders can actually hit bids with long stock, buy the stock back lower, and have the same"flat" position of stock and options upon closing the trade.
Look at it this way. If you own 1,000 shares of stock, but are long 10 puts and short 10 calls, you have a (delta) neutral position, which means that you are effectively flat the stock. If you sell the 1,000 shares and the stock goes down a dollar, and then you buy the stock back, you have made $1,000 and returned to the neutral position. There are other tools available, but suffice it to say we make more money on the downside when we can hit bids rather than wait for someone to buy stock on an uptick.
Don Bright is with Bright Trading (www.stocktrading.com), a professional equity corporation with offices around the US. E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
Originally published in the February 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.
Return to February 2002 Contents