Arbitrage
Where Will The Market Open?
by Ihor Vysotskyy
Here's how you can use fair value to determine where the market will open.
Turn on CNBC before the market opens and you will see the S&P futures quotes. How important are they? If you are an experienced trader, you know that the Standard & Poor's 500 futures contract, which is based on the S&P 500 index, is a valuable forecasting tool. But what exactly is the connection between the S&P 500 index and futures on this index, and how can this connection help define where the market will open?
FUTURES VS. CASH
The S&P 500 is a capitalization-weighted index with an aggregate market value of 500 companies that represent major industries. The S&P 500 futures contract is a commodity contract based on the S&P 500 cash index. It represents the "obligation to deliver" the value of the index on a certain future date (the expiration date).
Two factors should be considered when evaluating the S&P futures contract and the relationship between the futures contract ("futures") and the S&P 500 index ("cash"). First is the spread between the futures and the cash. If the futures trade at a value above the cash, then it is referred to as trading at a premium. If the futures contract trades at a value below the cash, it is called trading at a discount. To calculate the premium (discount), all you have to do is subtract the cash value of the S&P 500 index from the value of the S&P futures contract.
Take a look at the following example:
In this example, the spread or premium is 4.00. Once you know the premium, the next step is to determine the fair value. The formula for fair value (FV) is as follows:S&P futures = 844.0 Spx = 840
FV = SPX*(1+r)t / Div (Equation 1) Spx = spot price of the S&P 500 index r = interest rate on a six-month Treasury bill Div = Dividend sum derived from the stock owned during the life of the futures contract t = Days remaining until expiration of the futures contract (in years).
FIGURE 1: ARBITRAGEURS AT WORK. On this five-minute chart of the S&P 500, notice how the index fell 2.5 points within minutes of the open.
...Continued in the July issue of Technical Analysis of
STOCKS & COMMODITIES
Excerpted from an article originally published in the July 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.