“Fair Value”, what it is and why it is important every morning. It doesn’t surprise me that people don’t know exactly what it is, because it’s really not that easy to explain, let alone understand! But let me give you the “ups and downs” so you have an idea of what’s going on.
“Fair value” refers to the “proper” relationship between futures and cash. What is “cash”? It is the S&P 500 index. Through a complex formula using current short-term interest rates and the amount of time left until the futures contract expires, it can be determined what the difference between the futures “should” be. and the cash.
When the spread is at fair value, where it “should” be, there is no theoretical advantage to owning futures instead of cash, or vice versa. For professional investors and large institutions, when the spread is at fair value, it doesn’t matter economically to them whether they own the futures or the actual stocks that make up the S&P 500. Their buying and selling decisions will be driven by other factors. . But when the spread falls below fair value or moves above it by a large enough margin, then one of the options (stocks or futures) will become more attractive than the other, and they will sell one and buy the other.
Generally very loose, if the futures are way above fair value, they will dump those futures and buy the underlying stock, thus closing the spread and causing a “bull” market. On the other hand, if the futures are way below fair value, they will sell the stock, take the money, and buy the futures. This is why stocks “generally” follow the action of futures.
Therefore, in the morning it is quite useful for us to look at futures against fair value. For example, one day futures were below fair value and sure enough, we opened with the DOW down around 35 and the NASDAQ down 5. So the indicator worked that day. Some days it won’t work as well and sometimes the futures suggest significant dumping and yet we get minimal selling. Don’t forget that along with futures versus fair value, we also need to be aware of global events, news will often move the market more than anything else.
