Fair Value and Short Term Stock Trading

Traders often misunderstand or simply do not know about the importantance of Fair Value. This article will explain the concept of Fair Value, show why Fair Value is important, and how you can use Fair Value to develop a real trading edge.

The key to keep in mind is that Fair Value is one of the factors that triggers institutional buy/sell programs. Therefore, it is critical to have an understanding of this concept. Knowing if the program trading that is often based on signals from Fair Value will be primarily focused on the sell side or buy side for the day is crucial information for the day trader.

Let's start with the basic definition of Fair Value. Fair Value in its most basic form is the value of the Standard and Poors' 500 Index (S&P 500) plus the interest required to buy all 500 of the stocks minus the dividend checks paid by these stocks. CNBC often lists the Fair Value figure on the upper ticker on your TV prior to the opening bell at 9:30 EST.

There is some debate over the accuracy of the CNBC number, and you should be aware that this debate exists. But it's not relevant for this article.

That's all well and good, but just why do I need to know this?

Here is why: index arbitrage programs are based on the concept of Fair Value. These index arbitrage programs are normally institutional trading strategies that take advantage of the spread between the futures price and the cash index. They do this by buying one and selling the other to capture the difference as profit.

Sometimes over 70% of the NYSE volume is attributable to program trading, therefore the importance of understanding how it works is obvious.

The spread between the futures and cash index is called the Premium or PREM for short. One can obtain the PREM figure on most charting platforms such as E-Signal. PREM usually ranges between -$5.00 and +$5.00.

When the PREM reaches extreme levels, institutional buy/sell programs often kick in, throwing the stock market in one direction or the other. When you observe a stock or index turning on a dime, when you least expect it, this can be the result of institutional programs being triggered by the PREM. For example, on the day that I'm writing this, the PREM for the SP 500 is $1.45, and it is postulated that buy programs were set at $3.35 and sell programs at -$.55.

Stock day traders would be well advised to keep abreast of these figures and watch the PREM while trading. If the numbers are hit, and the corresponding move begins, it is highly likely the move will continue. Knowing this information provides a real edge to the stock day trader.

Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.