The stock market came back down to earth yesterday after a two-hour trip to nowhere caused by speculators playing Wall Street's newest high stakes game with stock index options and futures contracts.
Plunging dramatically as soon as trading began yesterday morning, the Dow Jones Industrial Average took only minutes to prove that the strong gains made in the closing hour of trading Friday were the result of stock index investing strategies rather than any widespread trend toward higher prices.
In the last hour of business Friday, the closely watched Dow Jones average had jumped almost 25 points to the second-highest close on record. But in the first hour of trading yesterday, the Dow dropped 12 points, wiping out any hopes for a big stock market rally.
The two-hour blip in prices was blamed on stock index futures and stock index options -- two similar investment vehicles that permit speculators to ride the ups and downs of the whole stock market for less that it would cost to invest in every stock.
A stock index option or futures contract gives the purchaser the theoretical right to buy at a predetermined price a "market basket" of shares representing all the stocks included in some stock market indicator such as the Standard & Poors 100-stock index. If the S&P 100 index goes up, holders of index options make just as much money as if they had purchased all 100 of the stocks.
Officials of all the major stock, options and futures markets have formed an Intermarket Surveillance Group, which is scheduled to meet Thursday to review the impact of Friday's trading for possible irregularities, said Donald Solodar, a senior vice president of the New York Stock Exchange.
When the Securities and Exchange Commission and Commodity Futures Trading Commission first approved index contracts, they assured Congress the new investments would have no impact on the market itself. "This was not anticipated by anyone," said John Mielke, director of surveillance of the CFTC.
Describing the unusual two-hour swing in the market as "a trading effect, not a problem," Mielke said the phenomenon shows how interrelated all financial markets have become.
In the three years since trading in index futures and options began, speculators have developed elaborate trading strategies for making money from gyrations in the prices of stocks, options and futures.
Under some of these strategies, speculators not only invest in index options but also simultaneously buy or sell all of the stocks included in the index, hoping to benefit from changes in the relationship between the value of the index and the price of the underlying securities.
That strategy can lead to dramatic swings in stock prices on days when options and futures contracts fall due. Friday was one of those days, the last day of trading for the two most popular index investments -- the S&P 100 options traded on the Chicago Board Options Exchange and the S&P 100 futures traded on the Chicago Mercantile Exchange. Holders of thousands of June S&P options and futures contracts had to close out their positions by Friday or be stuck with worthless investments.
The expiration day went off without a hitch at the two Chicago markets, but there were difficulties at the New York Stock Exchange, said Solodar.
A huge volume of buy orders flooded the exchange at the end of what would ordinarily have been a quiet Friday, Solodar said. In the final hour of trading, 41.7 million shares were traded, almost 20 million of them in the final 10 minutes of business.
Because index option and futures values are determined by the final price on the stock exchange, many traders send in what are called "market at close" orders to buy or sell stock at whatever is the final price for the day.
On Friday, the last-minute business was almost all buy orders, most of them placed by stock index speculators who had to buy stock by the end of the day to cover positions they had taken in the futures or options markets.
As a result of the heavy buying, the Dow Jones Average exploded Friday afternoon, jumping by 24.75 points (the biggest gain since January 21) to close at 1,324.48 -- the second highest close ever. Nearly half of Friday's gain in the Dow Jones average was attributed by analysts to a takeover bid for General Foods Corp., but the rest apparently was caused by buying pressure from stock index traders. Virtually all of those gains were wiped out yesterday morning.
Solodar said the New York Stock Exchange had been prepared for the heavy last-minute trading and handled it without serious problems.
"Anytime you have such a concentation of orders there is a concern," he said. The fear was that "if the orders were so one-sided, some of the firms couldn't buy as much stock as they wanted."
Days such as Friday "have become a market phenomena" since the advent of stock index options and futures, Solodar said. Crunches have been the heaviest on the third Friday of March, June, September and December, when stock index futures and options expire on the same day.