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Understanding Fair Value

What is fair value?

When weighed against movement in futures (agreements to buy or sell an underlying asset on a specified future date, at today's price), fair value is a good indicator of where stocks will head immediately after the opening bell.

Fair value is a technical measure of the correct relationship between futures and a stock index. The actual relationship between futures and an index is called the spread or the premium. Fair value remains constant throughout the day, but the spread is constantly changing because the futures contracts and the stocks that make up an index trade independently of each other.

Fair value is most often calculated for the S&P 500 , and large institutional traders use it to set up program (or computerized) trading.

Through the trading day, the spread generally stays pretty near to fair value. But futures continue to trade on the Chicago Mercantile Exchange for another 15 minutes after stocks finish trading, and then they trade throughout the night and into the morning in the electronic Globex session. As a result, the spread is often out of whack with fair value when the stock markets open at 9:30 a.m. EDT the next morning. Trading programs are essentially going to rapidly put the spread and fair value back into whack.

What Fair Value Really Says

The short of it? If the futures ran higher overnight or in the morning before the opening bell, there's going to be buying so that stocks can catch up with fair value. If the futures went lower, there's going to be selling to bring stocks back into line with fair value. Strong or weak preopen trading in the futures can also indicate the marketplace's reaction to news, either after the close or before the open, such as an influential company's earnings report or a release of major economic data.

The Calculation

There are several formulas for arriving at fair value, but it is essentially calculated by adding the closing price of an index to the interest you'd pay if you were to borrow that sum, minus the dividends you would receive on the stocks in the index if you actually owned them. The number of days left until the current futures contract expires is figured in as well. As the quarterly expiration date approaches for the futures, fair value gets smaller and smaller.

TheStreet.com's fair value graphic includes fair value for both the S&P 500 futures and the Nasdaq 100 futures, along with the change that would be needed to take the futures to fair value. The Nasdaq 100 tracks large technology companies, so it is a good indicator of how technology shares will trade in early action.

The fair value numbers TheStreet.com uses for the S&P 500 are calculated by Prudential Securities. For the Nasdaq 100, we do our own calculation, using a spreadsheet developed by TSC futures columnist Howard Simons .

OK, We've Got Fair Value. How Are the Futures Trading?

You can find Globex futures quotes at the Chicago Mercantile Exchange's Web site, on this page: http://www.cme.com/cgi-bin/gflash.cgi . Financial-news television networks also broadcast Globex futures quotes before the market opens.

During the regular trading session, you can get quotes on the S&P 500 futures here: http://www.cme.com/market/prices/r_sp.html . You can get quotes on the Nasdaq 100 futures here: http://www.cme.com/cgi-bin/prices.cgi?prices/r_nd.html . (The point changes on the CME site omit the decimal point, so if the change column says +820, for example, that means the contract is up 8.20 points.)

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