Washington investors will be eager to try their hand at stock index speculation, if federal regulators proceed with plans to create a family of new investments, local commodity brokers predict.
They see a ready market for stock index futures and stock index options among sophisticated investors who have already adopted to trading Treasury bills, foreign currencies, mortgage futures and stock options.
Stock index speculation is regarded as an arcane craft by many small investors and as little more than gambling by congressional critics, but within the industry it is seen as the logical extension of a decade's development of techniques for minimizing the risk of increasingly volatile financial markets.
Barring last minute snags, the Commodity Futures Trading Commission is scheduled to give birth to the first of a new species of investments tomorrow by approving a plan to buy and sell futures contracts based on the Value Line Index of stock prices.
Whether speculating on stock indexes becomes an accepted part of the U.S. financial marketplace or fails embarrassingly will depend on their acceptance by individual speculators and institutional investors.
The economic justification for stock index futures is not to permit people to make money by guessing whether the stock market will go up or down, but to provide a way for institutional investors to buy insurance against major swings in the market.
Advocates of the new investment vehicles list half a dozen ways in which they will enable investment bankers, mortgage brokers and pension fund managers to protect their investments against a swing in the market.
"My guess is you'll probably see large institutions who want to hedge using it more than individual speculators , at least at first," predicts veteran Washington commodity broker Howard Abbott of Drexel Burnham Lambert.
"Stock index futures should be more popular in Washington" than speculating on soybeans, corn or other farm products, agreed Wayne Hutton, assistant vice president and office manager for Merrill Lynch Commodities Inc., the futures trading arm of Merrill Lynch, Pierce, Fenner and Smith.
"People in Washington are more interested in what goes on at the Federal Reserve Board or the Treasury" than on weather in the corn belt, hence more attracted to investment opportunities that reflect those interests, he explained.
Politics and policy decisions will be of more help to people buying stock index futures than balance sheets or bottom lines, the traditional yardsticks of stock investing.
Stock indexes are designed to reflect the rise and fall of the daily tide of prices of broad segments of the stock market. Dow Jones & Co. will not allow its Dow Jones Industrial Average to be used for speculation, but there are proposals to utilize most of the other major indicators.
The New York Stock Exchange wants to sell options based on the NYSE composite index and, through its New York Futures Exchange, plans a futures contract based on the same index. The Chicago Mercantile Exchange has applied to trade futures based on the Standard & Poor's 500 Stock Index.
The Chicago Board Options Exchange has bundled some of the individual stocks on which it now trades options into 10 industry groups and wants to sell index options on each group. The Chicago Board of Trade has invented indexes based on 10 industrial groups--autos, airlines, banks, etc.--and wants to trade futures on each of them plus the total of all 10 groups.
Though other indexes may be better known, Value Line Index futures are expected to be the first to be authorized because the Kansas City Board of Trade's proposal was filed before any of the others.
Here's how it will work:
The Value Line Index tracks the prices of 1,700 stocks traded on the New York, American and over-the-counter markets. The price of the stocks is quoted as an index. The Value Line Futures contract will be worth 500 times the index. The index stood at 128.79 Friday; at that price the contract was worth $64,400.
The Kansas City Board of Trade tentatively plans to require speculators to make an initial margin deposit, or downpayment, of $4,000 to buy a Value Line Futures contract.
The Kansas City board may raise the margins, however, to avoid a confrontation with the Federal Reserve Board, which insists it has the legal authority to set margin requirements on all investments in stocks or bonds, including stock index futures. While disputing the Fed's authority, Kansas City officials reportedly are considering boosting the margin to 10 percent of the contract's value in hopes that will placate the Federal Reserve.
Each time the Value Line index changes by .01, the value of the futures contract will change by $5. A full one-point change in the index will mean a $500 change in the value of the futures contract, explained Neil S. Weiner, the economist for the Kansas City Board of Trade.
Most days the index doesn't move that much, Weiner said, and the biggest one-day change ever was 5.14 or $2,570. If the index drops by 8 points, the entire $4,000 initial margin investment would be wiped out.
Historically the Value Line index usually moves up or down eight points over a period of 12 to 19 days. That means a speculator who guesses wrong about the direction of the market can expect to lose the $4,000 within two-and-a-half to four weeks of trading.
Under the rules of futures trading, the $4,000 margin is not all a speculator can use. Technically speaking, a commodity margin is not a downpayment, but instead a "good faith deposit" to assure the buyer makes good on the contract.
If a speculator buys Value Lines futures when the contract is worth $64,000 and the stock market collapses, dropping the value of the contract to $40,000, the speculator can lose $24,000.
Many commodity speculators try to limit their losses by giving their broker a "stop order" to sell the contract when the loss reaches a certain point. But sometimes when prices are falling fast, there will be no one to sell the contract to. That happened when silver prices collapsed a couple of years ago; people who bought silver futures contracts at $30 an ounce watched helplessly as the price plunged to $10, unable to sell.
The loss potential is the biggest risk of using futures contracts. It will be possible to speculate on stock indexes with less risk if, as expected, the Securities and Exchange Commission eventually approves trading in stock index options.
If the Value Line index is at 129, it might be possible to get options to buy the index at 135. If the index climbs to 145 before the option comes due, the options buyer will make $5,000. But if the index falls to 125, the option becomes worthless. All the customer loses, however, is the price paid for the option.
With both futures and options, of course, it is possible to make money when prices are falling. Someone who expects the stock market to fall could sell a Value Line futures contract at today's price of 129. The margin will be the same as for buying a contract, $4,000.
If the Value Line index drops to 115, the seller makes a $7,000 profit on the 14-point decline, because it is possible to "buy back" the contract for less than it was sold for.
Likewise, it is possible to buy a "put option" that gives the right to sell a stock at today's price. If the market price drops, you make money by selling stock for more than it is worth.
Most futures and options transactions are settled with a cash payment rather than by taking delivery of stock or soybeans, but it is always possible to get the physical product rather than cash.
That won't be the case with stock index futures and options. Delivering one of each of the 1,700 shares in the Value Line index would be a physical and accounting nightmare. Instead, all the pending stock index futures applications call for settlement in cash.
The complexities of stock index futures trading and the potential for large losses have raised major concerns in Congress over how the new investments will be regulated.
Skeptical House Democrats like John Dingell of Michigan, chairman of a committee that oversees the SEC, and subcommittee chiefs Timothy Wirth of Colorado and Benjamin Rosenthal of New York doubt that there is an economic need for speculating on stock indexes. The economy has gotten along fine without stock index futures, they contend, and the new investments will be used mainly for gambling on the stock market.
Not so, insists Walter Vernon, president of the Kansas City Board of Trade, who lists several ways in which institutions and private investors could use the Value Line Index or similar vehicles.
The most common use, Vernon said, will be to hedge against a general decline in the stock market.
Say an investor spots a promising company whose profits are likely to increase, so the price of its stock goes up. The investor runs two risks in buying the company's stock. First is the specific risk that the company won't improve its profits, so the stock price doesn't gain. Second is the general risk that the entire stock market will turn down; if that happens, even the stock of growing companies could fall.
To hedge the investment in a particular stock, the investor could buy the shares and sell stock index futures. If the market as a whole turns sour, the investor may lose on the stock, but still make money on the index futures.
Similar hedging techniques are commonly used by dealers in government-insured mortgages who buy and sell Government National Mortgage Association futures to protect themselves against changes in interest rates. ecause stock index futures are such an unproven concept, however, there are doubts about whether investors will really use them for hedging. A survey of institutional investors filed with the CFTC found two-thirds of them weren't interested.
Only one major bank responded to the CFTC's request for comments on Value Line futures, and it was extremely critical. "The contract is purely speculative in nature and thus serves only to further the reallocation of monies away from productive economic ends," said Harris Trust and Savings Bank of Chicago.