Clues To Market Direction With The S&P 500 Premium by Jean-Olivier Fraisse, CFA
Need a clue to short-term market direction? The premium between the Standard & Poor's 500 futures and the corresponding cash index may help, provided you understand how it is determined, what its theoretical (or fair) value is and how program traders use it.
The S&P 500 index is based on the stock prices of 500 different companies with an aggregate market value of some 80% of the value of all stocks traded on the New York Stock Exchange. It is a capitalization weighted index; each component stock's price is multiplied by the number of common shares outstanding for that company, and the resulting market value is totaled. The total market value of all 500 firms is compared with that of the base period to derive the index price. A S&P 500 futures contract is an agreement between seller and buyer to deliver and take delivery, respectively, of a portfolio of stocks represented by the S&P 500 stock index at a specified future date. The delivery is actually a cash settlement of the difference between the original transaction price and the final price of the index at the termination of the contract. In practice, however, cash settlements occur in daily increments until the contract terminates, as the contract's trading price changes.
The value of the S&P 500 futures can be calculated by multiplying the futures price by $500. For example, with a futures price of 328.51, the value of the contract is 328.51 • $500, or $164,255.