532 Part V: Index Options and Futures 
The key to determining whether it will be profitable to trade some derivative 
security - options or futures - against a set of stocks is generally the level of premi­
um in the futures contract itself. That is, if the S&P 500 Index is at 405.00 and the 
futures are trading at 408.00, then there is a premium of 3.00 - the futures contract 
is trading 3.00 points higher than the index itself. The absolute level of the premium 
is not what is important, but rather the relationship between the premium and the 
fair value of the future. We will look at how to determine fair value shortly. 
The futures are the leaders among the derivative securities, especially the S&P 
500 futures. Whenever these become overpriced, other derivative securities will gen­
erally follow suit. There are also futures on the NYSE Index, the Value Line Index, 
and the Japanese Nikkei 225 Index. Moreover, there are cash-based index options on 
the S&P 500 Index (as opposed to the futures options on that index) and the NYSE 
Index. These other securities would include the QEX (S&P 100) options and NYSE 
futures and options. It follows as well that when the S&P 500 futures become under­
priced, the other derivative securities quickly fall into line. If the other derivative 
securities don't follow suit, then there is an opportunity for spreading one market 
against another. That type of spreading can frequently be profitable, and is discussed 
in the next chapter. 
The normal scenario is for most of the derivative securities to follow the lead of 
the S&P 500 futures. When this happens, the only thing that is fairly priced is the 
index itself - that is, stocks. Consequently, the logical way to hedge the derivative 
security is to do it with stocks. The small investor might hedge his own individual 
portfolio, although that would not be a perfect hedge since his own portfolio is not 
composed of the exact same stocks as any index. If the index is small enough, such as 
the 30-stock DJX, then one might buy all 30 stocks and sell the futures when they are 
overpriced. This is a complete hedge and would, in fact, be an arbitrage. In the case 
of a larger index such as the S&P 500, it would be possible only for the most profes­
sional traders to buy all 500 stocks, so one might buy a smaller subset of the index in 
hopes that this smaller set of stocks will mirror the performance of the index well 
enough to simulate having bought the entire index. We take in-depth looks at both 
types of hedging. 
Even if the investor is not planning to use these hedging strategies, it is impor­
tant for him to understand how they work These strategies have certain ramifications 
for the way the entire stock market moves. In order to anticipate these movements, 
a working knowledge of these hedging strategies is necessary. The first thing that one 
must know in order to implement any of these hedging strategies is how to determine 
the fair value of a futures contract.