There's nothing quite like the feeling of waking up, all bright and eager, and getting the first news of the day: "S&P 500 futures are down 18 points in overnight trading, and Nasdaq futures are lower by 60. It looks like Wall Street is in for a rough opening."

What!? Whose idea was this, and exactly where did those numbers come from, anyway? More importantly, who is out there buying or selling stock index futures well in advance of the official market openings, and why are they doing so?

These premarket futures trades, as we shall see, reflect market sentiment, provide both offensive and defensive trading opportunities, and allow institutional investors to manage their performance relative to their benchmark. They provide a snapshot of market sentiment on the exchange opening, but have little further forecast content.

Touching The Basis

First, let's define some things about stock index futures. An investor always has a choice between buying a basket of stocks equivalent to the S&P 500 or another index in the cash market and buying a futures contract.

A futures contract is the obligation to take delivery (long) or make delivery (short) of an underlying commodity. In the case of an S&P 500 future, the owner is contracting to receive a predetermined amount ($250 x Index) on the third Friday of the expiration month, currently June 16, 2000. This contract is settled in cash, not by delivering a basket of all 500 stocks in the index. The owner does not have to hold the contract until expiration. He can close his obligation by selling the contract at any time. Each point on the index is worth $250, and the minimum fluctuation, or "tick" is 0.10, or $25.

If we buy the cash stocks, we're incurring an opportunity cost, as we could have invested in Treasury bills at no risk instead. Because futures do not require an upfront payment other than their margin payment, they do not incur this opportunity cost, and therefore we should be willing to pay more for futures than for the stocks themselves. However, the owner of the stock is in line to receive both the dividend and the interest on that dividend, whereas the owner of future receives nothing. This is a holding cost on the future.

This difference between the stock-index futures price and the price of the cash stock index is called basis. Basis has a fair value: To get it, we add the interest cost of holding the stocks and subtract the expected dividends. Higher interest rates will expand the basis, as will lower dividend rates. Let's look at a basis case study for the S&P 500.

At the close of business on May 5, the S&P cash index was at 1,432.63, the risk-free (three-month Treasury bill) rate was at 6.67% for the 41 days remaining on the June contract, and the S&P 500 stocks were expected to pay out $2.48 in dividends over that period. The fair value of the future is calculated at 1,441.08, a basis of 8.45.

Market Expectations

In reality, the June S&P 500 futures settled at 1,439.00, or 0.14% below fair value. Is this a cause for concern? It could be: Should this basis rise to a level where we can buy the cash stocks at their offer price and sell the futures at their bid price and cover all of our costs, a "buy program" will commence. Just the opposite will occur if the futures decline too far relative to the cash; arbitrageurs sell the cash stocks and buy the undervalued futures in a "sell program."

If we woke up to find the S&P futures down 18.00 from Friday, we should expect, all else held equal, to see a sell program on the exchange opening. This would consist of selling the overvalued stocks and buying the undervalued futures. All of this brings us back to the question of who was willing to sell -- or buy, it works both ways -- with these futures so far from their fair value price. Are these traders smarter than we are, stupider, or just more anxious to get going?

Who And Why

The real answer is "all of the above." Equities trade around the clock in markets around the world, and it doesn't take much to get a stadium-like wave going. We saw this over and over again during the 1997-1998 Asian/Russian crises. Stock markets in Europe may be affected by currency problems, and this may spill over into bond markets, and then into U.S. stocks trading in third markets during early morning hours. We can track the movement of these stocks and get a good idea of where the U.S. market is likely to open.

Next, most U.S. government reports are issued before the stock-exchange opening. A bullish employment report, for example, may send futures scurrying higher in anticipation of a higher cash-market opening. Many professionals, most prominently index-option traders, have big bets on market direction. Since the index options (OEX, SPX, NDX) on the Chicago Board Options Exchange do not open until at least 80% of their constituent stocks are trading, futures often are the only way of controlling losses in early going.

Mutual-fund managers and other institutional investors use futures as well to gain or shed exposure to the market as their cash position dictates. Let's say a fund manager is in the happy position of receiving $100 million to invest after the previous day's close. Overseas markets are rising, U.S. stocks are rising on third markets such as block (10,000 shares or more) trading desks in London and on fourth markets such as the Instinet computer network, and all economic data is bullish. The manager will be underperforming his S&P 500 benchmark unless he deploys his cash quickly.

The manager can calculate quickly how many futures to buy to duplicate the index: ($100,000,000/($250 x 1432.63)), or 279. This is a much quicker and cleaner transaction than trying to buy $100,000,000 worth of the same stocks prior to the opening. Of course, the basis may expand and trigger a buy program on the exchange open. The transaction works in reverse for reducing exposure in the face of fund outflows.

Of course, this transaction is an open invitation to "it seemed like a good idea at the time." We are all familiar with rapid rejections of both higher and lower openings.