The Fair Value Trading Strategy, Explained

In the financial field littered with esoteric concepts and technical jargon, investors have a lot to keep track of to effectively play the markets.

To level the field, proprietary trader and Pre-Market Prep radio co-host Dennis Dick set out to explain the strategy of fair value equities trading.

Related link: How To Use S&P 500 Futures To Predict Market Movement 

The Ideal Scenario

Dick uses the opening fair value strategy taught by Bright Trading Founder Don Bright.

The theory is that, when the S&P 500 futures are trading up or down a particular percentage, the stocks comprising the index — at least, those unaffected by company news — will likely reflect that activity.

“I’ll have some stocks that are down, some stocks that are up, but overall, you start to look at betas [and] you look at how closely the stock is correlated with the S&P futures,” Dick said. “As you have more technical trading systems, as you have more statistical arbitrage systems, you see these correlations get even closer and closer.”

Take General Electric Company GE’s stock, which Dick said is very closely correlated with S&P futures. When the market is up 1 percent, GE should be up about 1 percent. On Tuesday morning, GE was trading down 0.23 percent, while the market index was down 0.3 percent.

“That’s holding very well with what you might think is fair value,” Dick said.

How To Act On The Strategy

The first step in fair market trading is determining the stocks worth playing — generally the top components of the S&P 500, excluding oil companies that move more with the price of oil.

The next step is to consider beta to determine appropriately fair values. Financials, for example, have a higher beta than the markets, so when the S&P 500 is down, financials are down slightly more. A company with a beta of two — twice the market — will likely open up or down twice as much as the market does.

Company news is also a significant factor.

“If there’s news on it, you’ve got to take those stocks and throw those stocks completely out, though, because if a stock is upgraded, it’s probably going to open up,” Dick said. “It doesn’t matter what the overall market does.”

Considering the sum of these conditions, investors employ a trading strategy of buying stocks opening too low and selling those opening too high relative to fair market value.

The GE Case

“If the market’s trading down like 0.3 percent today, and GE was to, let’s say, open up, [I] might try to short that, thinking it’s going to come back,” Dick said. “Short that and buy the actual S&P 500 futures against it, or the SPY you could do against it. And then you’re trying to just grab the difference between where GE opened and where the SPY is currently trading.”

A profitable trade, then, involves “surrounding” a value deemed fair.

“Let’s just say, hypothetically, SPY was trading down 1 percent,” he said. “If GE opened down 1.5 percent, I would maybe buy GE at the open. If GE opened down only a half percent, I would maybe sell short GE at the open and then do the SPY against it, looking to grab that half of a percent.”

Justifying The Difference

If a stock opens too high or too low relative to the S&P value, it's simply a function of supply and demand, Dick said. 

“Sometimes, you’ll have a big buyer off the open maybe in GE, and that’ll push the price a little bit too high,” he said. “Or maybe you’ll have a huge seller that’s going to push the price a little bit too low.”

Listen to the full discussion at 25:00 in the clip below.

PreMarket Prep is a daily trading ideas show focused on technical analysis and early morning movers. Listen to PreMarket Prep and chat live with our hosts, guests, and other listeners every weekday morning from 8 to 9 a.m. ET. Related Link: The Most Overpaid CEOs In S&P 500 Companies That Largely Underperformed The Market