It takes sophisticated, high-speed computers to keep track of the minute-by-minute profit opportunities and tens of millions of dollars to cover all the bets, but when saavy, quick-thinking traders play Wall Street's fastest-growing trading game, they can reap millions of dollars in profits with virtually no risk.
The tactics sometimes confound small investors by causing the stock market to zoom upward or drop precipitously for no expected reason. They delight investment managers who use the strategy to improve their yields on billions of pension fund dollars.
The game has many names. Some call it "program trading" or "basket trading" or "index arbitrage." Its opponents call it bad news for small investors and claim it artificially causes the stock market to soar or to plunge. Its proponents say it doesn't hurt the market, adds liquidity and reduces risk.
From the futures pits in Chicago to the trading rooms of New York to the halls of Washington's regulatory agencies, questions are being asked about the impact of huge programs that combine investments in the stock markets with deals in stock index futures. Lawmakers and regulators are trying to decide what, if anything, to do about the basket strategy.
Program trading allows institutional investors to profit from the difference between the price of a stock index such as the Standard & Poor's 500 and the price of a futures contract on that index. A futures contract based on a stock index is an agreement to buy or sell a specific number of stock index units at a specified price on a stipulated date. If the price of a futures contract on the S&P 500 index stands at 190, for example, the value of one contract would be 190 times $500 -- the multiplier used for a futures contract -- or $95,000.
Some experts say the price of the S&P futures contracts is largely determined by market psychology, rising and falling in line with optimism or pessimism about general stock market conditions.
On the day the space shuttle exploded, pessimistic traders instantly dropped the price of the futures contracts. When the overall stock market did not plunge, as expected, the futures price went back up.
The idea is to to try to make a profit when the price of stock index futures contracts diverges from the price of the actual stocks that make up the index. When index futures are priced significantly higher than the stocks in the index, basket traders sell the futures and simultaneously buy stocks that match the price of the index. They lock in their profits regardless of the movement of the market because prices of futures contracts always match up with the price of the actual commodity on the day the contracts expire.
Using a simplified example, if a stock index on Wall Street was at 185 and that stock index future was selling for 190, a basket trader would jump at the chance to buy stocks that represent the index and sell an equivalent amount of futures contracts and pocket the five-point difference. The investor also gets the benefit of dividends while the stocks are held.
No matter whether prices rise or fall during the term of the futures contracts, a substantial profit is made. If the prices of stocks fall, the profit on the futures contracts will more than offset the loss on stocks. And, if the prices of stocks increase, any loss on the futures contracts will be more than offset by the gain in stock values.
The basket strategy seeks to produce a profit that is two or three percentage points above what could be earned by investing in Treasury bills. It's barely worth the bother to conduct such complicated strategies for anything less than that, and only occasionally possible to earn much more.
This trading game cannot be played by just any investor. Basket trades involve hundreds of stocks and millions of dollars. They generally are executed by brokerage firms for banks, pension funds and investment managers. Computers are required to instantly calculate, transmit and analyze the fluctuations of the S&P index and the S&P futures, spot the opportunities when the spread between the two prices becomes profitable, and trigger the barrage of buy and sell orders.
The operations departments of large brokerage firms use computers to do the massive number of calculations involved in instantly buying or selling millions of dollars worth of stocks. Computers print the 500 or more tickets that 40 or 50 traders need to rapidly execute a basket trade on the stock exchange floor within minutes.
One New York firm keeps basket trades ready and waiting on the floor of the New York Stock Exchange at all times, waiting for institutional clients who need to make quick investments. The baskets usually come in $5 million, $10 million and $25 million sizes. Larger baskets require the purchase of 325 to 500 stocks at a cost of $25 million to $50 million.
Once a buy program is completed, an identical sell program for that basket is put on standby, awaiting the right opportunity to be sold. The selling can be completed on the day the stock index futures expire, but sometimes the profits can be claimed sooner when a falling market causes index and futures prices to converge.
Controversy over the impact of buy-and-sell programs flared recently when the Dow Jones industrial average plummeted 39 points in one day on Jan. 8. That drop was attributed, in part, to the impact of massive selling by traders "unwinding" their stock index trading programs.
Of particular concern to regulators is the explosive impact that "basket" sales or purchases can have on the market on "Expiration Fridays." These are the trades made at the closing bell on four Fridays a year when futures contracts expire. Because most basket trades require the sale of millions of dollars of stock at the closing price on expiration day, there is a tendency for the market to drop dramatically. But the pattern has not been neat. On the June 21, 1985, expiration, the DJIA shot up 25 points, driven by buy orders. On Aug. 6, 1985, in advance of the September expiration, sell orders drove the market down nearly 22 points.
The Commodities Futures Trading Commission moved to ease expiration-day problems when it approved two new index futures last October. They were the Nasdaq 100 Index at the Chicago Board of Trade and the S&P OTC 250 Index at the Chicago Mercantile Exchange. To remove pressure on the thinly traded over-the-counter stocks on expiration day, the CFTC insisted on some other way of settling the contracts. Given a choice between using the average price over several days to determine the final value of index future contracts or requiring traders to sell some of their contracts each day as expiration approaches, the markets chose the latter, which they call telescoping expiration times.
The exchanges have filed a protest, but the CFTC said it is studying their objections and expects no immediate action.
Donald W. McVitty, president of Foxhall Investment Management in Washington, which manages $200 million in funds, said that, as an institutional investor, he found that "this type of trading is very disconcerting." McVitty said the influence of program trading made it difficult for him to accurately judge the direction of the market, something that was important to his role as a large investor.
John Montgomery, president of the Washington Society of Investment Analysts, said the impact of basket trading "hasn't been so bad because it's been principally on the up buy side," but "it can give you the real shivers when it goes to the sell side."
Recalling the 39-point drop in the Dow Jones industrial average Jan. 8, Montgomery said, "You get a couple of back-to-back days like that and people will start to scream."
James B. Cloonan, president of the American Association of Individual Investors, has suggested to his members that basket trading involving the S&P 500 stock index is one reason small investors should avoid buying stocks listed on that index. He said the primary reason is that smaller stocks historically provide better returns than the blue chips. But the advent of basket trading also may have made the blue chips riskier, he noted.
Charles S. Comer, a market analyst for Oppenheimer & Co. and president of the New York Society of Securities Analysts, said basket trading had increased market fluctuation on occasion. He said its main effect was to "exaggerate the trend" in the market. Thus, a market's decline might accelerate after a sell program hit the street.
Comer also noted that program trading had "brought in participants who haven't any particular interest in the investment merits of what they are buying or selling . . . they just want to capture that spread."
The dollar value of stock-index-related programs at any given time varies with the size of the spread between the price of stocks and the price of futures contracts. At one point last year, there were an estimated $3 billion in index and other buy-and-sell programs. Wall Street observers say it currently is down to somewhere between about $100 million and $200 million.
Michael Creem, vice chairman of the New York Stock Exchange, said he believes that the basket trading made the market "less volatile." But he acknowledged that "Expiration Day makes me a little nervous" because so many sellers or buyers might be trying to get out the door simultaneously. Thus far, enough buyers and sellers had been found to complete the trading, he said.
Stanley B. Shopkorn, managing director of Salomon Brothers, whose firm was a major innovator of basket trading, commented: "There's no doubt that these instruments can, and do, have a short-term impact. But any time there are instruments that can add to the liquidity of the marketplace -- or offer the long-term investor a hedging technique -- that creates a plus factor. There never seems to be a complaint when these instruments force the market higher; the complaints persist when they force the market down."
John J. Davenport, an account executive at Wheat, First Securities of Richmond who studied basket trading, concluded that they "are contributing to the supply and demand of the market, not determining its course. On one day, the effect . . . may be dramatic, but on another day the pressure may be completely overshadowed by fundamental factors."
The basket trades have drawn the attention of Rep. John D. Dingell, chairman of the House Committee on Energy and Commerce, who asked the Securities and Exchange Commission what the SEC has done to "protect the integrity of these markets."
SEC Chairman John S. R. Shad responded with a memorandum citing potential benefits of program trading and SEC concerns, which include increased volatility on Expiration Days.