After Dow's fall, what future for futures market?
TEN days ago few people outside the financial services industry had heard about program trading and portfolio insurance. But since the Dow Jones industrial average's record 508-point fall last Monday and the stock market's continued wild swings, many stories have been written about the role the futures market and the related computerized activities played in the drop. The New York Stock Exchange halted program trading a week ago Tuesday to reduce market gyrations; it has not yet resumed.
``We probably would have had only a 100- to 150-point drop if it hadn't been for computers,'' says Frederick Ruopp, president of Chelsea Management Company in Los Angeles.
``Futures and options are like barnacles on a ship,'' says Marshall Front, executive vice-president at Stein Roe & Farnham in Chicago. ``They take their life from the pricing of stocks and bonds. When the barnacles start steering the ship, you get into trouble, as we saw last week.''
In the futures market a person agrees to buy or sell a commodity or financial instrument for a certain price on a specified future date. Buying futures contracts is a popular hedging technique because of the liquidity they provide. Futures are highly speculative and are used primarily by large portfolio holders.
The market fall also has reignited the traditional struggle between the futures markets, situated mainly in Chicago, and the New York Stock Exchange, as people try to assess what caused the market's confusion and volatility. In the most basic form, the Chicago futures and options exchanges and the New York Stock Exchange are competing for customers through the products they sell.
The futures market is playing the role of scapegoat in the fall, says Merton Miller, a professor of finance at the University of Chicago's Graduate School of Business. ``What's at issue is the battle for competitive turf.
``Last week everyone wanted to sell, and nobody wanted to buy. The fall wasn't a failure of the market,'' he adds. ``If there was a worldwide desire to get out of securities, you'd have a crash.''
President Reagan has ordered a three-member commission set up to study the market's fall, and the Securities and Exchange Commission has been watching trading activity to see if any steps should be taken to ease volatility. One congressional subcommittee held briefings on the market's fall this week.
Despite the blame the futures market and its related activities have received, futures do serve a useful purpose. Originally, commodities alone were traded on these markets, which helped give farmers more consistent prices for their products.
``Futures deflect the risk from people who don't want to bear it and give it to people who want it,'' points out Louis Mendelsohn, developer of the futures trading software ProfitTaker, and president of Investment Growth Corporation in Zephyrhills, Fla.
``You can't prevent the proliferation of futures contracts; you cannot go back unless you want to eliminate computers and satellite technology,'' Mr. Mendelsohn adds. Yesterday the Commodity Exchange launched a futures contract based on Moody's corporate bond index.
An investor can move in and out of futures easily. ``Futures provide a cheap vehicle for changing positions and shifting risk positions more quickly than [in] the stock market. When it's no longer cheaper to use futures, people go to stocks,'' says Professor Miller.
Margin requirements for futures buyers are only 7 percent of a contract's value, compared with 50 percent for common stock. Since the market's fall, the Chicago Mercantile Exchange, the leading stock index futures market, has increased margins from $10,000, to $15,000, then to $20,000 for speculators trading its popular and potentially lucrative S&P 500 index contract, based on a basket of stocks.
Last week computerized program trading in the stock index futures added to the markets' volatility. This trading, also called index arbitrage, searches for price differences between the index futures and their underlying stocks. Arbitragers search for split-second differences as they buy and sell basically the same product in the two markets. The transactions' speed adds volatility to the system.
The theory behind program trading makes for an efficient market, because it eliminates price difference between the markets. ``Program trading is getting a black eye, but as a concept it makes sense, because it's designed to reverse abnormal pricing,'' says Edward Dillmann, president of Derivative Markets Management Inc. in Chicago.
Generally the price relationship between the futures and stocks is close. On ``Black Monday'' the relationship came apart, causing trading programs, which kicked in before being halted, and eventually chaotic massive selling to push the market down into uncharted territory.
``You didn't expect everyone to trade in the futures at the same time,'' says Monte Gordon, director of research at the Dreyfus Corporation in New York. ``In the market's tremendous fall, the futures became the markets - and the problem.''
The role that program trading played in the fall is hard to determine, for a couple of reasons. First, the New York Stock Exchange halted it. ``By the exchange's accounts, program trading only affected a small part of the market,'' Miller says. ``Then Tuesday the NYSE stopped program trading, and the market continued to jump around. And overseas, where program trading does not exist, the markets behaved similarly to the United States.''
Closely related to program trading is a computerized hedging technique known as portfolio insurance, which plays futures contracts off the underlying stocks. When stock prices fall, the program orders the selling of futures contracts, cutting the investor's stock exposure and increasing cash holdings. In a falling market, an investor makes money on futures, which makes up for the loss in stocks. When the market climbs, an investor profits on stocks and loses on futures.
Many people cite portfolio insurance as a leading culprit in the market's fall. ``My own instinctive feeling is that portfolio insurance exacerbated the moves in recent days,'' says Robert Linton, chairman of the board of Drexel Burnham Lambert Inc. in New York.
The Commodity Futures Trading Commission, which regulates futures, has concluded from preliminary data that portfolio insurance played a greater role in the market's fall than program trading did in the futures markets. The agency expects to finish in the next few weeks a study on program trading's role in the fall.
Many people think the time is ripe for some regulation in the booming futures index market, either by limiting program trading or by imposing limits on price movements in futures contracts.
``I'm concerned the light of reason will not shine'' as Congress considers regulations, Miller says. ``It will be hard for the Chicago markets to defend themselves, because the stock exchange has a powerful voice in Washington and futures indexes are so new.''
Mr. Gordon of Dreyfus says greater regulation could have a positive note: ``It will restore credibility to the market, and credibility is what was beaten up.''