Now that I have written a bit about option contracts and futures contracts, I want to explain something that was a head-scratcher to me when I first started learning about the stock market: how the S&P 500 futures can be used to determine “fair value” and predict the S&P 500 opening price.
Take a deep breath. I know that was an earful. So let’s break this down.
Every day, the S&P 500 index opens for trading at 9:30 AM EST and closes at 4:00 PM EST. S&P 500 futures contracts, on the other hand, trade 24 hours a day in different markets all over the world. So before the New York Stock Exchange opens every morning, and the actual S&P 500 index stocks start trading, the direction that the S&P futures have been trading since the previous day’s close is a good indication of the directional “pressure” that the S&P 500 will face at the open that day.
Since the S&P futures are a “bet” on where the S&P 500 will end up at a point in the future, the price at which they trade is usually (but not always) slightly higher than the price of the S&P 500 index at any given time. The only reason for this “spread” between the price of the S&P 500 futures and the S&P 500 index is that people typically assume that the market rises over time, and they are willing to pay more for futures contracts based on that assumption.
If the S&P 500 closes the trading day at 2000 and the S&P 500 futures are trading at 2020 the next morning, that creates a spread of 20 points. Does that mean the S&P 500 should open 20 points higher? No.
What is this spread actually telling us? It’s telling us that futures buyers believe that the S&P 500 will be at least 20 points higher by the next futures expiration date, which, as of last Friday, was exactly three months away. So there is no direct correlation between the spread and the next day’s open, but common sense should tell you that there is some sort of relationship there.
My editor at Motley Fool always told me to break up boring text blocks with an image or graphic, so here’s one of Ryan Seacrest:
Now back to business: the missing piece of the puzzle of how to use the spread to predict the opening price for the stock market is a number called “fair value.”
Here’s where fair value comes in: theoretically, owning every stock in the S&P 500 on Friday and holding it for exactly three months would be the same as buying an S&P 500 futures contract and holding it until expiration. However, in the real world there are two practical differences between the two scenarios. The first difference is that it would be crazy expensive to buy shares of every single S&P 500 stock. How expensive? If you buy one share of Autozone($507.79), one share of Chipotle Mexican Grill ($654.58), one share of Google ($581.13), one share of Netflix ($443.90), aaaand one share of Priceline ($1166.35), your bill is up to $3353.75. That’s five stocks down, 495 left to buy…
So the first harsh reality is that, in order to actually buy the entire S&P 500, you would need to borrow money. And borrowing money always involves paying interest.
The other difference between buying the components of the S&P 500 and buying S&P futures is that many of the components of the S&P 500 pay dividends, and S&P futures contracts do not.
These differences between the S&P 500 and S&P 500 futures mean that an adjustment must be made to the value of the S&P 500 index price before making a fair, apples-to-apples comparison to the S&P 500 futures. This “adjustment” is called “fair value,” and here is the typical formula for calculating it:
FV = S * [1 + (I – D)]
FV = fair value
S = the current price of the S&P 500 index
I = the current interest rate to borrow funds to buy the S&P 500 components
D = the current dividend payment rate of the S&P 500 components
Since I’m a dork, I really like seeing what the fair value formula is and where is comes from. But luckily, CNBC crunches all the numbers for its viewers every morning, and here’s an example of how to use the numbers they come up with.
When I’m watching Sqwawk Box before the market opens, the scroll at the top of the screen shows the change in the S&P 500 futures and the “fair value” they have calculated. Let’s say, hypothetically, that the S&P 500 closes on Wednesday at 2000 exactly, and at the time the market closes the S&P 500 futures are priced at 2020. Next, let’s imagine that overnight, the S&P futures drop in price by ten points to 2010. On Thursday morning, CNBC calculates the “fair value” for the S&P 500 futures to be 2024. So the scroll on CNBC’s screen will read “S&P500 Fut -10 FV +4”
The minus ten comes from the ten point drop in the price of the futures since the previous day’s close, and the plus four comes from the difference between the calculated fair value of the futures (2024) and the 2020 price at the previous day’s close.
But the real meat on the bone of this convoluted discussion of fair value is that you can easily use these two numbers to determine what CNBC calls the “implied open.” If you take the change in the S&P 500 futures (-10) and subtract the fair value (+4), you get an approximation of the change that will likely occur in the actual S&P 500 index immediately after the opening bell. In our hypothetical scenario, (-10) – (+4) = -14, or a 14 point implied opening drop in the S&P 500.
If you are still reading at this point, wipe the tears from your face and listen: everything is ok. This is a complicated process. If you are a nerd like me, maybe you find it interesting. If not, you can breathe a sigh of relief: none of this really matters when it comes to your stocks.
But it’s nice to be able to glance at the TV screen in the morning when I’m making my protein shake, do a quick subtraction in my head, and know approximately how much higher or lower the S&P will open that day. However, practically speaking, there’s no easy way to use that information to make money. All you really need to make money in the stock market is common sense and a little K.I.S.S.
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