on the Globex and other exchanges. In contrast, mutual funds can be bought or sold only at themarket close, and the investor’s order must often be in several hours earlier. ETFs and index futures can also be shorted to hedge one’s portfolioor speculate on a market decline, which mutual funds cannot. And ETFscan be margined like any stock (with current Fed regulations at 50 percent), while index futures possess the highest degree of leverage, as investors can control stocks worth 20 or more times the value of cash.The trading flexibility of ETFs or futures can be either a bane or aboon to investors. It is easy to overreact to the continuous stream of optimistic and pessimistic news, causing an investor to sell near the low orbuy near the high. Furthermore, the ability to short stocks (except forhedging) or to leverage might tempt investors to play their short-termhunches on the market. This is a very dangerous game. For most in9
Index mutual funds are described in detail in Chapter 20.
CHAPTER 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options
TABLE
263
15–1
Comparison of Indexed InvestmentsETFs
Index Futures
Index Mutual Funds
Continuous Trading
Yes
Yes
No
Can Be Sold Short
Yes
Yes
Leverage
Can Borrow 50% Can Borrow over 90%Extremely Low
Expense RatioTrading Costs
None
Stock Commission Futures Commission
NoNoneVery LowNone
Dividend Reinvestment
Yes*
No†
Yes
Tax Efficiency
Extremely Good
Poor
Very Good
*Depends on policy of brokerage firm†Dividends built into price
vestors, restricting the frequency of trades and reducing leverage is beneficial to their total returns.On the cost side, all these vehicles are very efficient. Index mutualfunds are available at an annual cost of 20 basis points or less a year, andmost ETFs are even cheaper. But both ETFs and futures must be boughtthrough a brokerage account, and this involves paying both a commissionand a “bid-ask spread,” although these are quite low for actively traded indexes. On the other hand, most index funds are no-load funds, meaning thereis no commission when the fund is bought or sold. Furthermore, althoughindex futures involve no annual costs, these contracts must be rolled overinto new contracts at least once a year, entailing additional commissions.It is on the tax side that ETFs really shine. Because of the structureof ETFs, these funds generate very few if any capital gains. Index mutualfunds are also very tax efficient, but they do throw off capital gains. Thismeans funds must sell individual shares from their portfolio if investorsredeem their shares or if stocks are removed from the index. Althoughcapital gains have been small for most index funds, they are larger thanETFs.10 Futures are not tax efficient since any gains or losses must be realized at the end of the year whether the contracts are sold or not.Of course, these tax differences between ETFs and index mutualfunds do not matter if an investor holds these funds in a tax-shelteredaccount, such as an individual retirement account (IRA) or a Keogh plan(futures are not allowed in these accounts). However, if these funds areheld in taxable accounts, the after-tax return on ETFs is apt to be higherthan it would be for even the most efficient index fund.10From 1997 through 2006, there was no capital gain distribution from spiders (S&P 500 ETFs),while the Vanguard 500 Index Fund has had several (although none since 2000).
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The bottom line is that unless you like to speculate and leverageyour cash, you will want to avoid index futures. However, if you want tospeculate on the direction of the market, I recommend index options,which are described below and which limit an investor’s loss.Whether to hold ETFs or low-cost index mutual funds is a very closedecision. If you like to move in and out of the market frequently (which Ido not recommend), ETFs are for you. If you like to invest in the marketon a monthly basis or automatically reinvest your dividends, then noload index funds may be the better instrument. However, in recent yearsautomatic reinvestment of dividends has become possible for stocks andETFs if you specify that option to your brokerage firm. This developmentfurther tips the scale in favor of ETFs over index mutual funds.
INDEX OPTIONSAlthough ETFs and index futures are very important to investment professionals and institutions, the options market has caught the fancy ofmany investors. And this is not surprising. The beauty of an option isembedded in its very name: you have the option, but not the obligation,to buy or sell stocks or indexes at a given price by a given time. For theoption buyer, this option, in contrast to the futures, automatically limitsyour maximum liability to the amount you invested.There are two major types of options: puts and calls. Calls give youthe right to buy a stock (or stocks) at a fixed price within a given periodof time. Puts give you the right to sell a stock. Puts and calls have existedon individual stocks for decades, but they were not bought and soldthrough an organized trading system until the establishment of theChicago Board Options Exchange (CBOE) in 1974.What attracts investors to puts and calls is that liability is strictlylimited. If the market moves against options buyers, they can forfeit thepurchase price, forgoing the option to buy or sell. This contrasts sharplywith futures contracts with which, if the market goes against buyers,losses can mount quickly. In a volatile market, futures can be extremelyrisky, and it could be impossible for investors to exit a contract withoutsubstantial losses.In 1978, the CBOE began trading options on the popular stock indexes, such as the S&P 500 Index.11 The CBOE options trade in multiples11
In fact, the largest 100 stocks of the S&P 500 Index, called the “S&P 100,” comprise the most popularly traded index options. Options based on the S&P 500 Index are more widely used by institutional investors.
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of $100 per point of index value—cheaper than the $250-per-point multiple on the popular S&P 500 Index futures.An index allows investors to buy the stock index at a set pricewithin a given period of time. Assume that the S&P 500 Index is nowselling for 1,400, but you believe that the market is going to rise. Let usassume you can purchase a call option at 1,450 for three months for 30points, or $3,000. The purchase price of the option is called the premium,and the price at which the option has value when it expires—in this case1,450—is called the strike price. At any time within the next three monthsyou can, if you choose, exercise your option and receive $100 for everypoint that the S&P 500 Index is above 1,450.You need not exercise your option to make a profit. There is an extremely active market for options, and you can always sell them beforeexpiration to other investors. In this example, the S&P 500 Index willhave to rise above 1,480 for you to show a profit if you hold until the expiration, since you paid $3,000 for the option. But the beauty of optionsis that, if you guessed wrong and the market falls, the most you can loseis the $3,000 premium you paid.An index put works exactly the same way as a call, but in this casethe buyer makes money if the market goes down. Assume you buy a puton the S&P 500 Index at 1,350, paying a $3,000 premium. Every point theS&P 500 Index is below 1,350 at expiration will recoup $100 of your initial premium. If the index falls to 1,320 by expiration, you have brokeneven. Every point below 1,320 gives you a profit on your option.The price that you pay for an index option is determined by the market and depends on many factors, including interest rates and dividendyields. But the most important factor is the expected volatility of the market itself. Clearly, the more volatile the market, the more expensive it is tobuy either puts or calls. In a dull market, it is unlikely that the market willmove sufficiently high (in the case of a call) or low (in the case of a put) togive options buyers a profit. If this low volatility is expected to continue,the prices of options are low. In contrast, in volatile markets, the premiums on puts and calls are bid up as traders consider it more likely that theoptions will have value by the time of their expiration.12The price of options depends on the judgments of traders as to thelikelihood that the market will move sufficiently to make the rights tobuy or sell stock at a fixed price valuable. But the theory of options pricing was given a big boost in the 1970s when two academic economists,Fischer Black and Myron Scholes, developed the first mathematical for12
Chapter 16 will discuss a valuable index of option volatility called VIX.
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mula to price options. The Black-Scholes formula was an instant success. Itgave traders a benchmark for valuation where previously they usedonly their intuition. The formula was programmed on traders’ handheldcalculators and PCs around the world. Although there are conditionswhen the formula must be modified, empirical research has shown thatthe Black-Scholes formula closely approximates the price of traded options. Myron Scholes won the Nobel Prize in Economics in 1997 for hisdiscovery.13
Buying Index OptionsOptions are actually more basic instruments than futures or ETFs. Youcan replicate any future or ETF with options, but the reverse is not true.Options offer the investor far more strategies than futures. Such strategies can range from the very speculative to the extremely conservative.Suppose you want to be protected against a decline in the market.You can buy an index put, which increases in value as the market declines. Of course, you have to pay a premium for this option, very muchlike an insurance premium. If the market does not decline, you have forfeited your premium. But if it does decline, the increase in the value ofyour put has cushioned, if not completely offset, the decline in yourstock portfolio.Another advantage of puts is that you can buy just the amount ofprotection that you like. If you want to protect yourself against only atotal collapse in the market, you can buy a put that is way out-of-themoney, in other words, a put whose strike price is far below that of thecurrent level of the index. This option pays off only if the market declines precipitously. In addition, you can also buy puts with a strikeprice above the current market, so the option retains some value even ifthe market does not decline. Of course, these in-the-money puts are farmore expensive.There are many recorded examples of fantastic gains in puts andcalls. But for every option that gains so spectacularly in value, there arethousands of options that expire worthless. Some market professionalsestimate that 85 percent of individual investors who play the optionsmarket lose money. Not only do options buyers have to be right about
13
The original article was published in 1973: Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, vol. 81, no. 3, pp. 637–654. Fischer Blackwas deceased when the Nobel Prize was awarded in 1997. Myron Scholes shared the Nobel Prizewith William Sharpe and Bob Merton, the latter contributing to the discovery of the formula.
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the direction of the market but also their timing must be nearly perfect,and their selection of the strike price must be appropriate.
Selling Index OptionsOf course, for anyone who buys an option, someone must sell—orwrite—an options contract. The sellers, or writers, of call options believethat the market will not rise sufficiently to make a profit for options buyers. Sellers of call options usually make money when they sell optionssince the vast majority of options expire worthless. But should the marketmove sharply against the options sellers, their losses could be enormous.For that reason, most sellers of call options are investors who already own stock. This strategy, called buy and write, is popular withmany investors since it is seen as a win-win proposition. If stocks godown, they collect a premium from buyers of the call, and so they arebetter off than if they had not written the option. If stocks do nothing,they also collect the premium on the call, and they are still better off. Ifstocks go up, call writers still gain more on the stocks they own thanthey lose on the call they wrote, so they are still ahead. Of course, ifstocks go up strongly, they miss some of the rally since they have promised to deliver stock at a fixed price. In that case, call writers certainlywould have been better off if they had not sold the call. But they stillmake more money than if they had not owned the stocks at all.The buyers of put options are insuring their stock against price declines. But who are the sellers of these options? They are primarily thosewho are willing to buy the stock, but only if the price declines. A seller ofa put collects a premium, but he or she receives the stock only if it fallssufficiently to go below the strike price. Since put sellers are not as common as call sellers, premiums on puts that are out-of-the-money are frequently quite high.
THE IMPORTANCE OF INDEXED PRODUCTSThe development of stock index futures and options in the 1980s was amajor development for investors and money managers. Heavily capitalized firms, such as those represented in the Dow Jones Industrial Average, have always attracted money because of their outstanding liquidity.But with stock index futures, investors were able to buy the whole market, such as represented by the popular indexes.Ten years later, exchange-traded funds gave investors still anotherway to diversify across all markets at low cost. These ETFs had the fa-
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miliarity of stocks but, like index futures, much higher liquidity and superior tax efficiency. Today when investors want to take a position in themarket, it is most easily done with stock index futures or exchangetraded funds. Index options give investors the ability to insure the valueof their portfolio at the lowest possible price and save on transactioncosts and taxes.Despite the opposition of such notable investors as Warren Buffettand Peter Lynch, there is no hard evidence that these index productshave increased volatility or harmed investors. In fact, it is my belief thatthese index products have increased the liquidity of the world’s stockmarkets, enabled better diversification, and led to higher stock pricesthan would be available without them.
16
CHAPTER
MARKET VOLATILITYThe word crisis in Chinese is composed of two characters: the first, thesymbol of danger, . . . the second, of opportunity.
A comparison of the Dow Jones Industrial Average from 1922 through1932 and 1980 through 1990 is shown in Figure 16-1. There is an uncannysimilarity between these two bull markets. In October 1987, the editorsof the Wall Street Journal, looking at the then-incomplete version of thechart shown in Figure 16-1b, felt the similarity was so portentous thatthey printed a similar comparison in the paper that hit the streets onMonday morning, October 19, 1987. Little did they know that that daywould witness the greatest one-day drop in stock market history, exceeding the great crash of October 29, 1929. Ominously, the market continued to trade very much like 1929 for the remainder of the year. Manyforecasters, citing the similarities between the two periods, were certainthat disaster loomed and advised their clients to sell everything.But the similarity between the 1929 and the 1987 episodes stoppedat year’s end. The stock market recovered from its October 1987 crash,and by August 1989, it hit new high ground. In contrast, two years afterthe October 1929 crash, the Dow, in the throes of the greatest bear market in U.S. history, had lost more than two-thirds of its value and wasabout to lose two-thirds more.269Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
FIGURE
16–1
1929 and 1987 Stock CrashesFigure A
1922 – 1932
400
350
Dow Index Level
300
250
200
150
100
Monthly501922
1924
Daily
1926
1928
Aug
Sep
Bull Market
Figure B
Oct
Monthly
Nov
Dec
1930
1932
1929 Crash
Post Crash
Daily
Monthly
1980 – 1990
3000
2750
2500
Dow Index Level
2250
2000
1750
1500
1250
1000
Monthly7501980
1982
1984Bull Market
270
1986
Aug
Sep
Oct1987 Crash
Nov
Dec
1988
1990
Post Crash
CHAPTER 16 Market Volatility
271
What was different? Why did the eerie similarities between thesetwo events eventually diverge so dramatically? The simple answer isthat in 1987 the central bank had the power to control the ultimatesource of liquidity in the economy—the supply of money. And, in contrast to 1929, it did not hesitate to use it. Heeding the painful lessons ofits mistakes in the early 1930s, the Fed temporarily flooded the economywith money and pledged to stand by all bank deposits to ensure that allaspects of the financial system would function properly.The public was assured. There were no runs on banks, no contraction of the money supply, and no deflation in commodity and asset values. Indeed, the economy itself expanded despite the market collapse.The October 1987 stock market crash taught investors an important lesson—the world was indeed different from 1929 and a sharp sell-off canbe an opportunity for profit, not a time to panic.
THE STOCK MARKET CRASH OF OCTOBER 1987The stock crash of Monday, October 19, 1987, was one of the most dramatic financial events of the postwar era. The 508-point, or 22.6 percent,decline in the Dow Jones Industrials from 2,247 to 1,739 was by far thelargest point drop up to that time and the largest one-day percentagedrop in all history. Volume on the New York Stock Exchange soared to anall-time record, exceeding 600 million shares on both Monday and Tuesday, and for that fateful week the number of shares traded exceeded thevolume for all of 1966.The crash on Wall Street reverberated around the world. Tokyo,which two years later was going to enter its own massive bear market,fell the least, but it still experienced a record one-day drop of 15.6 percent. Stocks in New Zealand fell nearly 40 percent, and the Hong Kongmarket closed because collapsing prices brought massive defaults intheir stock index futures market. In the United States alone, stock valueson that infamous day dropped about $500 billion, and the total worldwide decline in stock values exceeded $1 trillion. A similar percentagedecline in today’s market would wipe out more than $7 trillion worldwide, a sum greater than the gross national product of every country butthe United States.1The stock market decline began in earnest the week prior to “BlackMonday,” as October 19 came to be called. At 8:30 a.m. on the preceding1
This is based on a $31.6 trillion worldwide total stock value in 2007, float adjusted. The sum wouldbe much larger if we included the value of government-held shares in emerging markets.
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Wednesday, the Department of Commerce reported that the UnitedStates suffered a $15.7 billion merchandise trade deficit, which at thattime was one of the largest in U.S. history and far in excess of market expectations. The reaction in the financial markets was immediate. Yieldson long government bonds rose to over 10 percent for the first time sinceNovember 1985, and the dollar declined sharply. The Dow Industrialsfell 95 points on Wednesday, a record point drop at that time.The situation continued to worsen on Thursday and Friday as theDow fell 166 more points, to 2,246. Late Friday afternoon, about 15 minutes prior to close, heavy selling hit the stock index futures markets inChicago. The indexes had fallen below crucial support levels, which ledto the barrage of selling in Chicago by those wanting to get out of stocksat almost any price.The December S&P 500 futures contract fell to an unprecedented 6points (or almost 3 percent) below the spot index. The development ofsuch a wide discount meant that money managers were willing to selllarge orders at a significant concession in order to sell fast, rather thanrisk that their sell orders for individual stocks might sit in New York, unexecuted. At the close of trading on Friday, the stock market had experienced its worst week in nearly five decades.Before New York opened the following Monday, there were ominous portents from the world markets. Overnight in Tokyo, the Nikkeiaverage fell 21⁄2 percent, and there were sharp declines in Sydney andHong Kong. In London, prices had fallen by 10 percent as many moneymanagers were trying to sell U.S. stocks trading there before the anticipated decline hit New York.Trading on the New York Stock Exchange on Black Monday waschaotic. No Dow Jones Industrial stock traded near the 9:30 openingbell, and only 7 Dow stocks traded before 9:45. By 10:30, 11 Dowstocks still had not opened. “Portfolio insurers,” described later in thischapter, heavily sold stock index futures, trying to insulate theirclients’ exposure to the plunging market. By late afternoon, the S&P500 Index futures were selling at a 25-point, or 12 percent, discount tothe spot market, a spread that was previously considered inconceivable. By the late afternoon, huge sell orders transmitted by programsellers cascaded onto the New York Exchange through the computerized system. The Dow Industrials collapsed almost 300 points in thefinal hour of trading, bringing the toll for the day to a record 508points, or 22.6 percent.Although October 19 is remembered in history as the day of thegreat stock crash, it was actually the next day—“Terrible Tuesday,” as
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it has become known—that the market almost failed. After opening upover 10 percent from Monday’s low, the market began to plunge bymidmorning, and shortly after noon it fell below its Monday close. TheS&P 500 Index futures market collapsed to 181—an incredible 40points, or 22 percent, under the reported index value. If index arbitragehad been possible, the futures prices would have dictated a Dow at1,450. Stock prices in the world’s largest market, on this calculation,were off nearly 50 percent from their high of 2,722 set just seven weeksearlier.It was at this time that near meltdown hit the market. The NYSEdid not close, but trading was halted in almost 200 stocks. For the firsttime, trading was also halted in the S&P 500 Index futures in Chicago.The only futures market of any size that remained open was theMajor Market Index that traded on the Chicago Board of Trade and represented blue-chip stocks similar to the Dow Industrials. These bluechips were selling at such deep discounts to the prices in New York thatvalues proved irresistible to some speculators. And since it was the onlymarket that remained open, buyers stepped in and futures shot up anequivalent of 120 Dow points, or almost 10 percent, in a matter of minutes. When traders and the exchange specialists saw the buying comeback into the blue chips, prices rallied in New York and the worst of themarket panic passed. A subsequent investigative report by the WallStreet Journal indicated that this futures market was a key to reversingthe catastrophic market collapse.2
THE CAUSES OF THE OCTOBER 1987 CRASHThere was no single precipitating event—such as a declaration of war, aterrorist act, an assassination, or a bankruptcy—that caused Black Monday. However, worrying trends had threatened the rising stock marketfor some time: sharply higher long-term rates caused by a falling dollarand the rapid development of a new strategy, called portfolio insurance,that was designed to insulate portfolios from a decline in the overallmarket. The latter was born from the explosive growth of stock index futures markets detailed in the previous chapter, markets that did not evenexist six years earlier.
2
James Stewart and Daniel Hertzberg, “How the Stock Market Almost Disintegrated a Day after theCrash,” Wall Street Journal, November 20, 1987, p. 1.
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Exchange-Rate PoliciesThe roots of the surge in interest rates that preceded the October 1987stock market crash are found in the futile attempts by the United Statesand other G7 countries (Japan, the United Kingdom, Germany, France,Italy, and Canada) to prevent the dollar from falling in the internationalexchange markets.The dollar had bounded to unprecedented levels in the middle ofthe 1980s on the heels of huge Japanese and European purchases of dollar securities and a strong U.S. economy. Foreign investors were attractedto high dollar interest rates, in part driven by record U.S. budget deficitsbut also by a strengthening of the U.S. economy and the capital-friendlypresidency of Ronald Reagan. By February 1985, the dollar became massively overvalued and U.S. exports became very uncompetitive, severelyworsening the U.S. trade deficit. The dollar then reversed course andbegan a steep decline.Central bankers initially cheered the fall of the overpriced dollar,but they grew concerned when the dollar continued to decline and theU.S. trade deficit, instead of improving, worsened. Finance ministersmet in February 1987 in Paris with the goal of supporting the dollar.They worried that if the dollar became too cheap, their own exports tothe United States, which had grown substantially when the dollar washigh, would suffer.The Federal Reserve reluctantly participated in the dollar stabilization program, whose success depended on either an improvement in theU.S. trade position or, absent that, a commitment by the Federal Reserveto raise interest rates to support the dollar.But the trade deficit did not improve; in fact, it worsened after theinitiation of the exchange stabilization policies. Traders, nervous aboutthe deteriorating U.S. trade balance, demanded ever higher interest ratesto hold U.S. assets. Leo Melamed, chairman of the Chicago MercantileExchange, was blunt when asked about the origins of Black Monday:“What caused the crash was all that f— around with the currencies of theworld.”3The stock market initially ignored rising interest rates. The U.S.market, like most equity markets around the world, was booming. TheDow Jones Industrials, which started 1987 at 1,933, reached an all-timehigh of 2,725 on August 22—250 percent above the August 1982 lowreached five years earlier. All world markets participated. Over the same3
Martin Mayer, Markets, New York: Norton, 1988, p. 62.
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five-year period, the British stock market was up 164 percent; the Swiss,209 percent; German, 217 percent; Japanese, 288 percent; and Italian, 421percent.But rising bond rates, coupled with higher stock prices, spelled trouble for the equity markets. The long-term government bond rate, whichbegan the year at 7 percent, topped 9 percent in September and continuedto rise. As stocks rose, the dividend and earnings yield fell, and the gapbetween the real yield on bonds and the earnings and dividend yields onstocks reached a postwar high. By the morning of October 19, the longterm bond yield had reached 10.47 percent despite the fact that inflationwas well under control. The record gap between yields on stocks and thereal yields on bonds set the stage for the stock market crash.
The Futures MarketThe S&P 500 futures market also clearly contributed to the market crash.Since the introduction of the stock index futures market, a new tradingtechnique, called portfolio insurance, had been introduced into portfoliomanagement.Portfolio insurance was, in concept, not much different than an oftused technique called a stop-loss order. If an investor buys a stock andwants to protect herself from a loss (or if it has gone up, protect herprofit), it is possible to place a sell order below the current price that willbe triggered when and if the price falls to or below this specified level.But stop-loss orders are not guarantees that you can get out of themarket. If the stock falls below your specified price, your stop-loss orderbecomes a market order to be executed at the next best price. If the stockgaps, or declines dramatically, your order could be executed far belowyour hoped-for price. This means a panic might develop if many investors place stop-loss orders around the same price. A price declinecould trigger a flood of sell orders, overwhelming the market.Portfolio insurers, who sold the stock index futures against largeportfolios to protect them against market decline, felt they were immuneto such problems. It seemed extremely unlikely that the S&P 500 Indexfutures would ever decline dramatically in price and that the whole U.S.capital market, the world’s largest, could fail to find buyers. This is onereason why the stock market continued to rise in the face of sharplyhigher long-term rates.But the entire market did gap on October 19, 1987. During the weekof October 12, the market declined by 10 percent and a large number ofsell orders flooded the markets. So many traders and money managers
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using portfolio insurance strategies tried to sell index futures to protecttheir clients’ profits that the futures market collapsed. There were absolutely no buyers, and liquidity vanished.What the overwhelming majority of stock traders once believedwas inconceivable became a reality. Since the prices of index futureswere so far below the prices of the stocks selling in New York, investorshalted their buying of shares in New York altogether. The world’s largestcorporations failed to attract any buyers.Portfolio insurance withered rapidly after the crash. It was dramatically demonstrated that it was not an insurance scheme at all becausethe continuity and liquidity of the market could not be assured. Therewas, however, an alternative form of portfolio protection: index options.With the introduction of these options markets in the 1980s, investorscould explicitly purchase insurance against market declines by buyingputs on a market index.