Program Trading And Fair Value

(Editor's note: Click here to read the Chicago Mercantile Exchange's (CME) short article on calculating fair value.)

As an intraday trader, your primary concern is not fair value, but the actual levels at which real buy and sell programs will kick in. If the spread widens to the buy program level listed in the "Views From The Trading Desk" commentary, it means program traders will be selling futures and buying stocks. If the spread narrows to our sell program level, program traders will buy futures and sell stocks. This is a standard arbitrage to enhance the return of holding the S&P 500.

There are variations that impact the specifics of program trading, but your primary concern is to know when program trading will affect your day trading.

This is the formula for fair value:

Fair Value (FV) = S{1 + ( I - D )}

Where

• S is the S&P 500 index;
• I is the amount of interest paid to the broker to borrow the money to buy all of the stocks in the S&P 500 index;
• D is the amount of dividends paid to you from all of the companies you own in the S&P 500 index.

The interest is calculated on a percentage lending rate from today until the date the S&P futures contract expires. The dividend income also is expressed as a percentage rate.

The short version of the fair value formula is the value of the S&P 500, plus the interest to buy the stocks, minus all of the dividends you get.

Actual premiums used for real-world program trading must include the cost of money (which can vary with different firms), execution slippage and any NYSE trading curbs (buy minus, sell plus), and commissions. CNBC does not calculate any of the real cost that determines the dollar premium you use, which even varies amongst program traders because of different costs.