Without going into a PhD diatribe of how one calculates fair value and its relationship to the futures price, I am going to provide you with a very basic understanding of the relationship and how the retail investor can use the information.
Very simply, first understand that the S&P 500 cash and S&P 500 future are completely different products. When referring to "fair value" one is simply taking the present value of the S&P 500, or cash, and factoring in the borrowing costs to own all of the stocks in the index, dividends and difference between the current day and front month future expiration in order to mathematically derive a fair value relationship between the cash and the future. *Keep in mind that when mentioning the fair value relationship we are always referring to the "spot" future, or what is commonly labeled the "front month". In today's case it would be the December 2013 future.
Most financial websites and media networks calculate fair value for the viewer, so no need to worry about the math. Just understand that the fair value is where the front month future should be trading, according to the mathematical calculation. However, with the futures market open through the night and the equity markets open for a limited session during the day, external factors, such as supply and demand, will often have the futures price deviating from fair value. It is this deviation that is often reflected by the media networks (i.e. CNBC, Bloomberg, Fox Business) in the pre-market hours in an effort to provide investors with an implied open for the index, or in other words: market sentiment.
The following is how it might appear on your screen:
S&P 500 Futures: +5 Fair Value: +7
So what does this mean?
In this example one might look at the TV and think, "GREAT," futures are indicating a higher open for the market, however at second look and with a little math the screen is actually showing a bearish sentiment. How? Remember...fair value is only a calculation of where the future "should be". Above, traders are pricing in a discount to fair value of 2 points (FV - S&P Future), which implies a lower opening for the cash index of 2.
Vice versa, if the pre-market data reads as follows, the sentiment would be bullish:
S&P 500 Futures: +7 Fair Value: +5
So what is the "implied open"?
In this particular case it is +2 points. I know...the math gets a little tricky. Remember to use fair value as your line in the sand. For this example the futures are trading at a premium to the fair value by 2 points, so traders are pricing in a rise in the index at the open.
While this relationship can appear very complicated, and has historically been used as an institutional indicator for arbitrage and program trading, the retail trader can also use the relationship as a basic indicator for market sentiment. Please note, however, that this information should not be used for stock or option selection, merely an indicator of market conditions.
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At the time of publication, Travis McGhee held no positions in the stocks or issues mentioned.