Pre-Market Futures: Fair Value Trading Strategy

Futures have always been the trading instrument of choice for investors that want to get a jump on the markets. Futures trading begins earlier than even pre-market equity trading. This is why futures are often referred to as pre-market futures. They can set the tone of the market movements for the rest of the day. Some investors rely heavily on pre-market index futures (tracking the S&P 500 and the Dow Jones Industrial Average) as an indicator for daily market sentiment through the fair-value trading model.

Fair Value Trading the Futures Markets

The E-Mini S&P 500 Futures Contract, along with other commodities and futures contracts, opens for trading on Sunday 6 PM ET. That’s more than 15 hours before the regular markets open. This makes futures one of the first instruments to react to any weekend news.

Futures prices are set by the same market forces that move all stocks, so tracking futures prices could give hints to opening stock prices. This type of analysis is what traders call fair value futures trading.

Futures fair value is defined as the price of the contract at which a buyer of the underlying asset would be neutral between buying the underlying and buying the future.

Since the fair value relates to the front-running contract, it is treated as a metric in determining whether it’s a better economic decision to buy the underlying asset at its current price or if it’s more reasonable to buy the futures contract.

Approximating the fair value of a futures contract is a simple sum of the current value of the underlying asset and it’s cost of carry until contract expiry. Fair value is an opportunity cost adjustment of investing in the underlying asset over the futures contract.

If Dow Jones Industrial Average Index is trading at $27,110 and the future (expiring in two months) is trading at $27,350, the fair value of the Dow futures will be the value of Dow and the interest receivable from placing that capital in a money market fund for two months plus any dividends that could have been received.

Despite the fact that many traders use futures as an indicator for intra-day performance, it doesn’t always work. Thanks to high frequency traders, the fair value discrepancy is corrected much faster once the markets open.

Additionally, futures’ price action is not always indicative of similar return profiles in the underlying asset and vice-versa. The underlying asset may increase, while the future value decreases. However, most equity and index futures correlate closely with the movements of the underlying asset, making it a reasonable pre-market indicator.

When traders refer to using pre-market futures to dictate the market sentiment, they are referring to comparing the pre-market futures price against the fair value.

The 2 rules of pre-market futures trading to remember:

1. If the futures value is higher than fair value this means investors expect the market to rise on the open.

2. If the futures value is lower than fair value this means investors expect the market to fall on the open.

Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.