Derivatives Can’t Make Market Go Where It Won’t

Just what the red-hot U.S. stock market needs: more ways to speculate!

Tongue only halfway in cheek, that was the reaction from some Wall Street veterans late last week after Dow Jones & Co. announced it will license options, futures and other “derivative” securities based on the venerable Dow Jones industrial average.

It was only a coincidence that the Dow index soared 130.49 points to a record high of 7,435.78 on Friday. However excited some investors may have been about the chance to bet on the Dow via new low-cost options and futures contracts, Friday’s rally was primarily fueled by a drop in interest rates after the government’s report of surprisingly modest job creation in May.

Still, Wall Streeters couldn’t help but wonder what Dow Jones’ decision to finally cave in and allow the creation of synthetic securities based on the 30-stock Dow index might mean for the bull market.

Contrarians, naturally, figured it’s another sign of a market peak: If Dow Jones is at long last losing its inhibitions about derivatives tied to its precious namesake index, this must be the end of the road for the 1990s bull march.

But then, we’ve all heard that one before.

Dow Jones resisted the siren call of derivatives licensing for 15 years, ever since the first stock index future contract--based on the still-little-known Value Line market index--began trading in February 1982 on the Kansas City Board of Trade, of all places.

Dow Jones executives continually said they worried about the potential for manipulation of stock-based derivatives, and thus of the market itself, by nefarious speculators. With futures contracts, in particular, a trader can effectively control an enormous amount of stock with little money down.

Today, one futures contract on the Standard & Poor’s 500-stock index, for example, gives the owner a $429,000 stock market bet for a mere $16,800 down payment, or 3.9% of the contract’s value.

While Dow Jones fretted all those years, Standard & Poor’s Corp. was quite happy to allow its broader blue-chip 500 to become the primary stock index for the burgeoning futures and options markets--and to collect a small fortune in licensing fees in the process.

Derivatives, of course, have become a mammoth global business since the 1970s, with synthetic securities based not only on stock indexes but also on bonds, currencies, commodities and other investments.

The rise of the personal computer made derivatives possible because it allowed Wall Street to use computer power to experiment with hybrid securities, and it allowed investors and traders worldwide to easily track the movement of the securities, and transact in them.

Last year, more than 20.4 million S&P; 500 futures contracts alone traded on the Chicago Mercantile Exchange, up from 12.4 million in 1992. The average daily dollar value of S&P; futures trades last year was $27 billion, far exceeding the daily dollar volume of stocks traded on the New York Stock Exchange.

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But what do those numbers really mean? Derivatives have long gotten a bad rap; they often are viewed as the market equivalent of alchemy, or even sorcery.

In fact, derivatives serve many positive purposes. Yes, they can be used by traders to make high-octane bets on market movements. They also allow investors to get into a market quickly, especially compared with the amount of time it can take to accumulate a portfolio of actual stocks.

In those contexts, derivatives are seen as purely speculative vehicles, perhaps raising the overall level of risk in the market.

But far less discussed is the role of derivatives as hedging tools: Futures and options contracts also are widely used to reduce risk, by allowing an investor to essentially buy insurance against a negative move in the market (and thus in his or her portfolio of “real” securities).

What’s key to remember is that, with derivatives as with any market transaction, someone is selling and someone else is buying. Both can’t be right in their respective decisions. But if one party is hedging, the idea of being “right” is relative: You buy insurance on your home, after all, but you don’t hope that you’ll be right that you needed it.

All that said, Dow Jones’ misgivings about permitting the creation of derivatives based on the Dow index didn’t look so silly in October 1987. When the stock market crashed that Oct. 19, slashing nearly a quarter of the market’s value in a single session, derivatives trading--specifically, rapid-fire dumping of S&P; 500-stock index futures contracts by institutional investors--immediately got the blame.

The truth was that, while futures contracts certainly were being jettisoned, so was every other equity-related security, including individual stocks. The problem for all equity sellers at that point was simply that there was nobody to sell to--which is always the way it is in a panicked market.

After 1987, another derivatives-based trading tactic, so-called index arbitrage, continued to be popular with some institutions and brokerages, causing a fresh outcry from many individual-investor advocates.

Index arbitrage involves using computers to take advantage of small, minute-by-minute discrepancies between the price of S&P; futures contracts in Chicago and the prices of the underlying stocks in the index in New York.

Depending on the discrepancy, a big investor would either buy the futures and sell the stocks, or vice versa. Because of the large sums of money that can be involved, the stock market can suddenly surge or plummet on a day when index arbitragers are active, even if there is no other substantial market-moving news.

Facing an irate and frightened public after the market crash, the New York Stock Exchange ultimately slapped controls on index arbitrage traders, basically forcing them to slow their activities whenever the market moves sharply intraday.

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Yet such trading still goes on, and sometimes is quite significant. But while it used to grab headlines daily, today it’s rarely even discussed on Wall Street. And clearly, the continued presence of index arbitragers in the market, and any extra volatility generated by derivative securities in total, haven’t been impediments to stocks’ advance worldwide.

What many investors have come to realize is that, although derivatives-related trading games can create “noise” in the market on a short-term basis, on a long-term basis they can’t make the market go anywhere it doesn’t really want to go.

Thus, if the bull market wants to go higher, the availability of futures and options contracts on the Dow--by far the world’s best-known stock index--will probably help the cause by attracting more money into the equity market.

And when this bull finally expires, and investors decide they want out of stocks, it’s a good bet that the new Dow options and futures will lead the plunge.