In this morning’s “Our View,” MrTopStep.com CEO Danny Riley mentions “something so basic that most traders don’t even look at it: premium levels, fair value (FV) and volume.” For months, I’d heard Danny mention buy and sell programs and premium. I put the fair value into our daily report and looked back at premium and price history. And as often happens, I was also thinking about robots.
Fair value premium is the major driver of price action
If you watch CNBC with the volume up, you’ve heard them say “fair value” every morning, when they quote the pre-open S&P 500 futures [^GSPC:SNP].
If you’re like me, you probably thought “fair value” was something like the blue book price for a used car. And you might have thought about whether stocks and index futures were overpriced or a bargain.
Little did I know fair value premium is the major driver of price action in index futures. China’s PMI, the Fed, housing prices, unemployment—they may affect investors’ feelings about where the long-term value is.
But it’s the premium between fair value and futures that moves the price up and down the ladder, tick by tick. Why? Robots, of course. (More on that below.)
And since funds and banks use futures to hedge their portfolios, as in the recent rotation into tech stocks, fair value plays a big role in the stock market as well.
Premium and index arbitrage
To put it simply, a difference between the current futures price and fair value constitutes a premium. If futures is above fair value, then you sell the futures and buy the cash S&P. If futures is below fair value, then it’s a bargain; sell the cash and buy the futures. Then you liquidate the spread and keep the difference as profit.
You’re probably saying, I’ve never done that kind of trade. You probably haven’t. You may also be saying, sometimes that premium is just a few points or ticks. You’d have to be really fast to profit. Yes, you would. Maybe faster than humans can be.
Learning from the robots
60% to 75% of trades are done by index arbitrage buy and sell programs, algorithms that trade the difference between the actual current price and the future price, selling the higher one and buying the lower. To do this, they (and other algos) lay down buy and sell stops–often months in advance–and then run them when the time comes. This is how a small move turns into a run, as it did Friday.
So what can mere humans do against the droid army? Keep being human, but learn one thing from the bots. They do what they plan to do.
When their stop is hit, they exit. When the market meets their entry conditions, they pull the trigger without hesitation. They don’t fantasize about big winners or let a loss make them go back and analyze their childhoods.
They trade like, well, machines, knowing that losing is part of succeeding and being just as willing to take losses as profits, as long as their edge gives them profit that exceeds the loss. Otherwise, unlike humans, they stop trading.
I’ll say it again: there is no holy grail of investing or trading. You are the holy grail.
Finally, the money part
Last Friday morning, futures were 10 full points below fair value before the open. And had been negative 10 of 15 days this year. That was enough to tell you how the day was likely to go. Wasn’t it?
One more thing: remember that robots, even more than humans, remember price levels of significance, where there was a lot of volume and a lot of time spent.
Those levels act as magnets on humans and perhaps even more on algorithms programmed to mirror human desire.
So is it any wonder the drop stopped on the red trendline? And will you be surprised when it drops to 1750 or 1715?
Let’s put some things together. The Friday-Monday rule says that Monday will continue Friday’s momentum.
And the Asian markets traded sharply lower. (My Asia Sunday Rule says that Asia will start a trend and then hand it off to the US to continue or will start and finish a move and let the US digest it.)
And the S&P futures has been below or at fair value most of the night but are now 5.46 points above as of 7 AM CT. Do these things suggest how today will probably go? A bounce and then continuation of the downtrend seems likely.
The next level down is in the low 1760s. I hesitate to write that because some of you will just short from Random Point A to Random Point B, lose money, and be sad. I hope you won’t do that. But then again, everybody gets what they want from the market.