By: Pat Crawley
The opening print is the most important price of the day. It represents the cumulative supply and demand of all orders submitted between the previous day’s close and the open, as well as the market maker’s reading of that order flow.
Due to this buildup of order flow, the opening auction often results in prices that diverge from a market maker’s idea of where the stock should be trading. The role of the market maker is to support the weak side of supply/demand to facilitate liquidity. So, when a stock diverges from the market maker’s idea of ‘fair value,’ an opportunity surfaces.
This is the rough idea behind what has become known as the fair value trading strategy popularized by proprietary trading firms in the 1990’s. It’s kind of like pairs trading, except you typically don’t hedge the trade unless your exposure becomes adversely large.
A Primer on Fair Value
Fair value trading is a very basic statistical arbitrage strategy based on a stock’s correlations with its parent index. The approach exists on the idea that when a highly correlated stock diverges from the index, that gap is usually closed relatively quickly, creating an arbitrage opportunity.
For instance, Disney (DIS) is highly correlated with the S&P 500 and has a beta of one, meaning its returns roughly mirror the S&P. When fair value traders see Disney open down 1%, while the market is only down 0.5%, all things being equal, that’s a buy signal, assuming no news is out on Disney.
The underlying assumption here is that sometimes the large buying or selling activity of OTF (other timeframe) participants will temporarily push the stock away from its fair value due to the short-term supply/demand imbalance.
How To Trade the Fair Value Strategy
The basic idea of the strategy is to identify stocks that are highly correlated with the /ES futures and take an opposing position in the stock when it diverges from /ES. For instance, if we’re to assume Company XYZ is highly correlated with /ES and has a beta of 1 (meaning it roughly moves 1% for every 1% that /ES moves), we would short XYZ when it is up 1% while the S&P is down 0.25%.
You’ll hear traders refer to this type of trade as aiming to “be on the same side as the specialist.” The role of a specialist (now referred to as designated market maker) is to open stocks at an appropriate level, based on the pre-market order flow. If one side of the market is weaker, DMMs are obligated to provide more liquidity to that side.
As explained earlier, the concept of fair value is quite simple. Find the stocks that are most correlated to their parent index. In this case, we’re using the S&P 500, but the strategy will work on foreign exchanges that utilize designated market makers as well.
Once you’ve identified highly correlated stocks, you want to find the level that /ES is implying they should open at. So, if there’s no news, a highly-correlated stock with a beta of one’s open should mirror that of /ES’ current price action. The implied open is the ‘fair value.’
So, if /ES is up 1% in pre-market trading, then a highly correlated stock with a beta of 1 should be up roughly 1%, as long as there’s no news out. If Disney, which has a beta of ~1 only goes up 0.3% in the morning, while the S&P 500 went up 1%, then Disney would be 0.7% below its theoretical fair value.
The general universe for this strategy is the top components of the S&P 500: companies like Walmart, Johnson & Johnson, and Apple. Still, practitioners of the strategy will often submit orders on hundreds of stocks. The base requirement is that the stock has a high correlation with the S&P 500.
Following that, we narrow the universe. Eliminate any stocks with news out, as they will perform differently from the index that day, and any stock with significant commodity exposure, like energy companies, will be excluded.
You are then left with a list of stable stocks that usually track the market with no fundamental change in the company that would cause the stock price to diverge from the S&P 500 heavily.
Traders who have the assistance of automation will regularly send dozens to hundreds of orders each morning and are generally only filled on something like 10-20% of them. An example of an order might be to buy Disney when it’s down 0.5% more than /ES and sell it when it’s up more than 0.5% than /ES. They would replicate orders like this, based on each stock’s beta and correlation levels.
To trade this strategy correctly, you must utilize the Limit-On-Open (LOO) order, which is basically a ‘fill-or-kill’ order that is only active for the opening auction, then canceled. Using these orders reduces the likelihood of any unwanted fills.
To submit a LOO order in Lightspeed, create a limit order, and select “OPG” under the “TIF” drop-down menu. The default selection is “DAY.”
Because most of these stocks are highly correlated, the fill ratio is normally manageable. However, when one is filled on too many orders on one side of the market, it may be necessary to hedge with S&P 500 futures (/ES), or $SPY, depending on your level of exposure. Because of the low share price of $SPY, its easier to be precise with your hedging, but it does require more buying power.
This type of strategy is popular in professional trading circles because of the order automation and buying power required to scale this strategy. The challenge here is to apply this strategy on a smaller scale.
I can think of several ways to do this, like choosing the cream that rises to the top–that is, only focusing on the most stable stocks that respect their correlations to the index. Your trade frequency will be lower, but these trades can be added to an already diverse toolbox of trading strategies and allow you to be active in the first few minutes of the trading day, something many traders shy away from.
While this strategy has been traded by floor traders and professional traders for decades, it’s imperative to do your research and testing with any trading strategy.
Active Trading with Lightspeed
Lightspeed, a division of Lime Brokerage, provides active traders with all the tools required to help them find success in stock trading, and we have been developing and honing our active trader platform to offer an optimal user experience. With the intuitive interface layouts and institutional quality stock and options scanners, we aim to help traders reach their goals, no matter what their strategy is. We also offer our clients some of the lowest trading fees in the industry.
The author has no positions in any of the securities mentioned.
Futures trading involves the substantial risk of loss and is not suitable for all investors. Each investor must consider whether this is a suitable investment since you may lose all of or more than your initial investment. Past performance is not indicative of future results.
Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services nor information provided by any of the above service providers and any service or information used to execute any trading strategies are solely based on the independent analysis of the user.