chter,traders said…”Scott McMurray. “Chicago Merc Sets Daily Limit On Price Swings—Aim Is toReduce Volatility In Stock-Index Futures And Options Trading.” The Wall StreetJournal, October 23, 1987.
30
Barron’s. “A Bad Two Weeks—A Wall Street Star Loses $840 Million.” November 2, 1987.
31
The magnitude of the decline the large order sparked was tremendous even ifone measures the price impact from the initial 230 offer to 195.
32
Barron’s. “A Bad Two Weeks—A Wall Street Star Loses $840 Million.” November 2, 1987.
33
Kathleen Pender. “‘Craziest I’ve Ever Seen’/Wild Trading Day for Stock Market/Dow Goes Way Up, Way Down.” San Francisco Chronicle, 24 January 1987. Thearticle notes:…Analysts said there was no economic news from the government orfrom abroad that would have set off the pandemonium. They blamedthe volatility on computerized trading programs operated by big brokerage houses.
34
The contract specifications called for the value of the futures contract to be $500times the stock index futures price. This gave the minimum tick a dollar value of$25. This was later changed to $250 times the index on November 1, 1997. Thetick size was increased to a “dime,” or .1, to maintain the dollar value of $25.
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35
James Sterngold. “Wall Street Day: Torrid Start, Sudden Chill.” The New YorkTimes. January 24, 1987.
36
Robert Lenzner. “Don’t Blame Program Trading, Firms Say.” The Boston Globe,January 27, 1987.
37
Scott McMurray. “Free Fall: Interest Rate Worries and Program Trading SendStocks Plunging—Automated Selling Generates Biggest One-Day Decline asVolume Sets a Record—A Fluke or a Positive Omen?” The Wall Street Journal,September 12, 1986.
9BUBBLES, CRASHES,CORNERS, ANDMARKET CRISES“A conventional valuation which is established as the outcomeof the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really makemuch difference to the prospective yield; since there will be nostrong roots of conviction to hold it steady. In abnormal timesin particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usualeven though there are no express grounds to anticipate definite change, the market will be subject to waves of optimisticand pessimistic sentiment, which are unreasoning and yet ina sense legitimate where no solid basis exists for a reasonablecalculation.”—John Maynard Keynes1
259
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The Silver CornerDuring the fall and winter of 1979, the prices of silver and gold rosesharply in volatile markets. At one point in late August and early September, silver rose for 13 consecutive trading sessions.2 Concern thatthe sharp increase in the price of silver was the result of manipulationprompted an investigation by the Commodities Exchange (COMEX)where most silver futures were traded at the time.3 Market participants were concerned about a potential squeeze or a corner in thesilver market where individuals who were short silver would beforced to cover their positions at artificially high prices. These fearsintensified as the price of silver continued to jump and deliverablesupplies of silver shrunk during the fall of 1979. This can be seen inthe following excerpt from the November 29, 1979 issue of The WallStreet Journal.…Traders agree that a key factor in the market’s behavior isthe potential shortage of silver available for immediate delivery. Silver in warehouses approved by the London MetalsExchange has declined by more than half in the past month,to 9.5 million ounces.On the COMEX, the number of contracts outstanding fordelivery in December represents about 45 million ounces, ortwo-thirds of all the Exchange’s deliverable supplies.4
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In reaction to these concerns, the two principal U.S. exchangesthat traded silver futures, the COMEX and the Chicago Board ofTrade (CBOT), imposed new position limits on silver futures andraised margin requirements.5 Fears of an immediate squeeze fell butreturned in December 1979. Contemporary news accounts attributed much of the silver purchases to Nelson Bunker Hunt and hisbrother William Jefferson Hunt (members of an immensely wealthyTexas family) and their largely foreign business associates. To besure, there were other factors besides the rumored efforts by theHunt brothers and their allies to drive the price of silver up. Fear ofinflation buoyed the demand for precious metals. Two geopoliticalfactors also helped spur the price rises in silver, gold, and platinum:the Iranian hostage crisis that began on November 4, 1979 and theSoviet invasion of Afghanistan that began on December 25, 1979.Nevertheless, the repeated use of the silver futures markets by theHunt brothers and their allies to purchase and take delivery of largequantities of silver induced a shortage in the deliverable supply of silver that reinforced the price increases. Simply put, silver futuresshorts were being squeezed as the Hunt brothers and their alliesamassed large quantities of silver. The extensive rally in silver futuresprices is depicted in Figure 9.1. Figure 9.2 depicts the largely coincident rally and subsequent break in gold futures prices during 1979and 1980.
262
4100.03900.0
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Daily trading range of NYMEX front month silver futures prices from May 1, 1979 to February 15, 1980.
FIGURE 9.1
Silver soars during 1979-1980.
12/1/79
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900.0
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900.001/21/80
850.00
1/21/80date.open 873.0date.high 873.0date.low 815.0date.close 834.0
800.00750.00700.00650.00600.00550.00500.00450.00400.00350.00300.00250.00200.005/1/79
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10/1/79
11/1/79
12/1/79
1/1/80
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5/1/80
6/1/80
Daily trading range of NYMEX front month gold futures prices from May 1, 1979 to June 30, 1980.
Gold rallies and falls during 1979-1980.
263
FIGURE 9.2
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On January 21, 1980, the price of spot silver reached a high of$52.50 per troy ounce, and COMEX silver futures prices also set anew high. The spot price of gold reached a high of $850 per troyounce that same day. The COMEX and the CBOT reacted byrestricting the silver futures market to liquidation-only trades andsharply increasing margin requirements on existing positions. Theseactions prevented the perceived shortage in the deliverable supply ofsilver from being exacerbated by parties who used new purchases ofsilver futures contracts to acquire physical silver. Not surprisingly, silver futures prices fell sharply in response to the new restrictionsimposed by the exchanges, as the following excerpt from The WallStreet Journal reveals.Silver plummeted $10 to $34 an ounce a record single-daydrop in prices. The slump followed restrictions placed byNew York’s Commodity Exchange [COMEX] on silver trading Monday. The Chicago Board of Trade yesterday…[forbid] traders to add on new positions in January, February,and March contracts.…Silver’s decline was accelerated by the record $143.50 dropin gold in New York…During the day Nelson Bunker Hunt,one of the big speculators whose buying helped push silver torecord prices, said he offered to buy up to five million ouncesat $40 an ounce, deliverable in Zurich, New York or Londonfrom anybody who has silver that’s deliverable.6Notice that Nelson Bunker Hunt’s proposed offer to buy up to 5million ounces of deliverable silver at $40 per ounce did not preventthe futures price of silver from falling significantly below $40. Noticealso how the sharp price decline in gold adversely impacted the silvermarket. A period of sharp price volatility followed for both gold andsilver, but the record high prices for both gold and silver would not betopped. For instance, the spot price of gold fell nearly $200 per troyounce in two days, or about 24%. The spot price of silver fell $22.25per troy ounce, or nearly 43%, during the same two day period. Theprices of both precious metals then climbed substantially higher.7
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The U.S. Commodity Futures Trading Commission subsequentlyinvestigated whether the Hunt brothers and their allies were activelytrying to corner the market for silver. The price action during 1979and early 1980 suggests that, if they were attempting to do so, theysucceeded for a while.There are two problems with attempted corners. The first problem is that supply may dramatically increase as price increasesbecause alternatives are found (thus reducing demand) and previously unavailable private holdings enter the marketplace (thusincreasing supply). This lessens the effectiveness of an attempted corner. There is anecdotal evidence that some heavy industrial users ofsilver (like firms in the photography industry) were able to obtainneeded silver by reprocessing it from old film after the price of silverrose dramatically. There is also anecdotal evidence that India (wheremany women store their wealth in the form of silver jewelry) wentfrom being a net importer of silver before the attempted silver cornerto a net exporter of silver. Similarly, there were numerous anecdotalreports of individuals selling their family silverware to take advantageof the high price of silver. Keeping the price of silver high requirescontinued purchases of silver if new supplies enter the market.The large holdings of silver that the Hunt brothers and their associates controlled needed to be financed. The Hunt brothers couldcontrol more silver if they borrowed to finance it. The Hunt brothersused the high value of their existing silver holdings as collateral tofinance the purchase of additional silver—that is, they were pyramiding on an existing trading position. This set the stage for a possiblepositive feedback trading episode in silver futures prices if a pricedecline—that required longs to post additional margin—inducedselling by other longs (cutting their losses short) and further pricedeclines. This is exactly what happened during early March 1980when the price of silver fell repeatedly and the Hunt brothersreceived a series of margin calls. The question that other market participants had to answer was whether the Hunts could continue to
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meet the margin calls if the price of silver continued to fall. News thatthe Hunts faced margin calls pushed prices down but the price of silver still remained relatively high.The second problem with attempted corners is also fundamental—namely, the only way to take a profit is to sell the commodity that wascornered. However, selling the commodity that was cornered maycause prices to fall, reducing the value of the remaining holdings.Moreover, the price decline associated with a sale might be magnifiedif other market participants believed that the corner could not bemaintained.The Hunt brothers devised a seemingly clever way around thisproblem. On Wednesday, March 26, 1980, Nelson Bunker Huntannounced in Paris the planned issuance of interest-bearing commodity bonds backed by 200 million ounces of silver—that is, bondswhose principal is redeemable in silver or in currency at the option ofthe issuer. According to press accounts at the time, the Hunt consortium planned to issue between $3 billion to $3.5 billion of bonds. Theannouncement was made after the silver market in New York wasclosed. Silver closed at $15.80 or down $4.40 from March 25. Thenext day, silver fell $5 to close at $10.80 per troy ounce.The announcement may have acted as a trading catalyst. Bondsare forward contracts on money and commodity bonds are forwardcontracts on the commodity in question. The bond issuer is sellingforward contracts, whereas the bond buyer is buying forward contracts. The proposed issuance of commodity bonds was an ingeniousway of selling silver forward and locking in profits.8 However, it didn’twork because market participants saw the proposed commoditybonds for what they were—an end run around selling in the forwardmarket directly and depressing the price of silver. Figure 9.3 depictsthe sharp decline in silver futures prices during the first few monthsof 1980.
4000.0
3/26/80date.open 1890.0date.high 1990.0date.low 1510.0date.close 1580.0
3800.03600.03400.03200.03000.0
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4200.0
6/3/80
Daily trading range of NYMEX front month silver futures prices from December 1, 1979 to June 30, 1980.
Silver plummets during 1980.
267
FIGURE 9.3
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TRADING CATALYSTS
A simpler explanation is that word of the Hunts’s inability to meetmargin calls at Bache Halsey Stuart—a large brokerage firm at thetime—leaked out and market participants smelled blood in the water.The Hunts had approximately $90 million in equity at Bache to coverthe over 4,000 silver futures contracts they had outstanding onWednesday, March 26. The Hunts held both spot and deferredmonth silver futures contracts. Price limits in futures markets meantthat the Hunts’s sizable positions in deferred futures contractsmonths were not fully marked to market. Bache estimated that if thedeferred futures prices were marked to the spot price of silver, theHunts’s equity would be approximately $50 million.9In May 1980 report to the Committee on Agriculture, Nutrition,and Forestry of the United States Senate, the U.S. CommodityFutures Trading Commission described the situation as follows.The Commission’s Division of Trading and Markets wasinformed at approximately 1:15 P.M. [on Wednesday, March26, 1980] that the Hunts had failed, for the first time, to meettheir margin calls at [their broker] Bache. On the evening ofTuesday, March 25, 1980, Bache advised Mr. W.H. Hunt thatadditional margin of $135,000,000 was required. Mr. Huntreportedly advised Bache by telephone that he was unable tomeet the margin call and acquiesced in the Bache positionthat it would begin immediately to liquidate collateral heldfor the Hunt accounts. Bache informed the Division that theHunt’s activity and positions in silver were so substantial thatdaily margin calls in excess of $10,000,000 had beencommonplace. Upon learning of Bache’s situation, membersof the Division of Trading and Markets’ staff contacted theCBOT and COMEX at approximately 1:30 P.M.…As of theclose of business on Tuesday, March 25, 1980, the Huntaccount at Bache held a net long silver position of 4,070 contracts. On Wednesday morning, Bache liquidated for theHunt’s accounts silver bullion in the approximate amount of
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$100,000,000 which had been previously deposited by theHunts as collateral. On Thursday, March 27, Bache liquidated 636 futures contracts so that the Hunt’s net long position as of the close of the business on Thursday, March 27 was3,434 contracts. On Friday, March 28, 1980, Bache advisedthe CFTC that they had sold 3,316 additional futures contracts. Thus, as of the close of business on Friday, March 28,1980, the Hunts’ position at Bache was represented by 38 netlong futures contracts and 80 warehouse receipts.10In any event, the market soon rebounded after the forced liquidation. The spot month silver futures contract price closed at $12.00 pertroy ounce on Friday, March 28, 1980.News of the Hunts’s plight acted as a trading catalyst in silver andin other markets. It sparked a flight to safety rally in Treasury bills andbonds and a selloff in stocks. It precipitated a rise in the U.S. dollarand declines in commodity prices (with some seemingly unrelatedcommodities experiencing limit down moves). Put differently, theinternal market catalyst in the silver market became an external market catalyst for price changes in other commodity and financial markets. The spillover effects of this event for other markets aredescribed in the following excerpt from an article by George McNairthat appeared in The Globe and Mail on March 28, 1980.A collapse of silver futures prices…is having wide rangingeffects on other commodity and financial markets…Led bysilver, commodity prices fell sharply. Gold was down $41 to$463 (U.S.) an ounce and copper fell 3.7 cents to 84.2 cents apound. Sugar, cotton, cattle and hogs all fell by as much aspermitted in a single day. Grains fell moderately.The stock markets’ decline was attributed in large part to thecollapse of silver and other commodity prices and the resulting forced selling. Bond prices, however, were firm.11At one point, the stock market as measured by the Dow JonesIndustrial Average was down almost 3% on news of stock market
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liquidations by Bache Halsey Stuart to meet some of the Hunt brothers’s margin calls on silver. The market later rebounded and closed at759.58, or down only 2.14 points, for the day.12 Not surprisingly, thefinancial crisis that the silver market meltdown precipitated induceda flight to safety. Treasury bill prices rose sharply as 13 week T-billyields fell almost one percentage point to 14.85% and the overnightFederal funds rate tumbled from 25% to 19%.13It is interesting to speculate on why the sharp decline in silverfutures prices affected a broad array of commodities. Although thesympathetic reaction of gold and copper futures prices makes someintuitive sense, the limit down moves of sugar, cotton, hogs, and cattlefutures prices and the moderate reaction of grain futures prices to thedecline in silver futures prices do not. The connection is weak at best.Perhaps, the commodities were all inflation hedges. Otherwise, thereis no apparent reason individuals or firms who were long silver to belong hogs, cotton, cattle, sugar, or grain futures. The common argument that individuals or firms who are long both silver and any of theaforementioned commodities need to sell these commodities to raisemoney is dubious.It would be misleading to leave the impression that the massiverise in silver prices was solely due to the actions of the Hunt brothers.Clearly, it was not. Geopolitical factors and fear of inflation contributed significantly to the run-up in precious metal prices. Theprice of gold rose sharply during this time period and its pricechanges sometimes led changes in silver prices. The actions ofexchanges also impacted silver futures prices. This is shown in thereaction of the silver futures market to the imposition of tradingrestrictions and increased margin requirements on silver on January22, 1980 when silver dropped $10 per troy ounce. That said, theactions of the Hunt brothers in acquiring their silver spot and futuresmarket positions and repeatedly taking delivery of expiring silverfutures positions had a substantial positive impact on silver (and other
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commodity) prices. Likewise, the unwinding of the Hunts’s silverpositions exerted a substantial negative impact on silver (and othercommodity) prices. This is shown in the reaction of silver futuresprices to news of the Hunt brothers’s inability to meet margin callsand plan to issue silver-backed bonds in late March 1980. These incidents demonstrate how factors internal to the market (e.g., anattempted corner, trading restrictions, and margin calls) can pushprices either sharply higher or sharply lower.Finally, the inability of the Hunts to meet margin calls illustratesanother problem that traders with large positions sometimesencounter—that is, cash flow risk. Simply put, a trader needs to havethe cash flow necessary to meet margin calls arising from short-termmovements in prices. Otherwise, the trader may be stopped out orforced out of a trading position due to a sudden sharp adverse movein prices.
Internal Market CatalystsNo discussion of trading catalysts would be complete without anexamination of market corners, squeezes, bubbles, crashes, and crisesand the factors that precipitate them. These market events are thequintessential examples of the effects of internal trading catalysts onmarket prices and volatility. These events also demonstrate theimportance of the trading decisions of key market participants andthe game-like nature of trading. These events are related in that eachis associated with significant changes in financial market prices andvolatility. They are oftentimes unrelated to fundamental economicfactors. These market events also exert a powerful impact on the popular imagination about the behavior of financial markets. However,these market events also differ in important ways.Corners and squeezes are attempts by some market participantswho have significant long positions to drive prices higher by forcing
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market participants who are short to cover their short positions. Forthis reason, corners are also known as short squeezes as the principalobjective is to force shorts to cover their positions at higher prices.Corners and squeezes are simply attempts to manipulate marketprices upward through strategic control of deliverable supply. Thesubsequent price increases largely result from reasons unrelated tofundamental economic factors.As the attempted corner of the silver market by the Hunt brothersand others demonstrates, successful corners are difficult to conduct,maintain, and profit from. Although a number of external factors(such as perceived inflation and the taking of American hostages inIran) reinforced the rally in silver prices, few observers would arguethat silver prices weren’t distorted for a considerable time period as aresult of the machinations of certain silver market participants.A more ingenious strategy for squeezing shorts occurred duringthe Salomon Brothers Treasury bid-rigging scandal of 1991. At thetime Salomon Brothers was a large investment bank and arguably thepremier fixed-income trading firm on the Street. Salomon submittedphony customer orders from large trading firms (which it laterreversed) at Treasury auctions with the objective of acquiring a largersupply of new 2-year Treasury note issues than the 35% it was allowedto purchase under existing Treasury guidelines. In one instance,Salomon was able to acquire 44% of 2-year Treasury notes sold atauction.14 Salomon used its control over a large fraction of the supplyof newly issued 2-year Treasury notes to squeeze dealers who wereshort the security in the when-issued market.15Many of the Treasury securities that dealers hold are financed inthe “repo” or collateralized lending market. Market participants canpledge (or lend) securities and borrow money or borrow securitiesand lend money in the repo market—that is, repo market participantsmust do both. The rate at which money can be borrowed or lent is thegeneral collateral rate if no securities are specified or the lower
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special rate if a dealer wants to borrow specific Treasury securities.When a security is in high demand or short supply, the price of thesecurity will rise and the special repo rate can approach zero if atrader needs to borrow the security in the repo market. Much of theprofit from the squeeze was earned in the repo market where dealerswho were short the 2-year Treasury note in the when-issued marketwere forced to lend money to Salomon at the below market specialrepo rate in order to borrow the 2-year Treasury notes that they wereshort.Neither the SEC nor the Treasury took kindly to Salomon’s bidrigging actions. Salomon was fined and almost closed as a result of itsattempted manipulation of the Treasury market. It also lost a largenumber of institutional clients who ended or suspended their dealings with the firm as a result of the scandal. Key executives resignedand Warren Buffet was brought in to temporarily run the firm.16Market crashes represent a sharp downward revaluation of anindividual asset, a market sector, or the overall market. Like bubbles,a market crash can occur over a protracted period of time (such asoccurred in the U.S. stock market during the 1973-1974 stock market) or very quickly. The popular imagination and most attentionfocus on crashes that occur quickly.A bubble is a situation in which the price of an asset feeds offof past price increases of the asset without regard to economicfundamentals—that is, past price increases of an asset class increasecurrent demand for, and the price of, the asset class. A bubble mayoccur in an individual asset, a market sector, or in the overall market.The rate of price increase tends to accelerate as time passes until thebubble peaks. The inflation of asset prices may occur over a protracted period of time or very quickly. Similarly, a bubble may deflateslowly or very quickly.Bubbles may be driven by fads, fashions, herd behavior, ormanias.17 Commonly cited examples of bubbles are the tulip bulb
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mania in The Netherlands during 1634-1635, the Mississippi Company bubble in France during 1719-1720, the South Sea Companybubble in Britain during 1720, the Japanese stock market in the late1980s, and the dot.com and technology stock bubble in the U.S. during the late 1990s and early 2000.Although there is little debate about whether sudden marketcrashes exist, the existence (and even definition) of market bubbles iscontroversial.18 The observation of a market crash does not mean thatthe crash was preceded by a bubble. Nor does the existence of a perceived market bubble mean that it will be followed by a sudden market crash. Thus, there need not be a single catalyst that precipitatesthe deflation of a market bubble.For instance, some market observers contend that there was abubble in the Japanese stock market during the late 1980s. However,the deflation of the Japanese stock market (which peaked at38,915.87 on December 29, 1989 as measured by the Nikkei 225stock index) started during early 1990 and occurred over an extendedperiod of time. Numerous factors such as rising interest rates, afalling yen, and a shift in focus by Soviet President Mikhail Gorbachev from foreign to domestic issues were catalysts for periodicselloffs in the Nikkei during January and early February 1990. Meanwhile, there was substantial demand outside Japan for newly issuedput warrants on the Japanese stock market (which were presumablyhedged by selling Japanese stock index futures).On Monday, February 26, 1990, the Nikkei 225 fell 1,569 points,or 4.5%, to close at 33,321. It had been down over 2,413 points during the trading day. As a result of this and earlier market declines (theNikkei was down 6.9% the previous week), the Tokyo StockExchange imposed some temporary restrictions on index arbitrageselling.19 Prices continued to bounce around but drift lower in thedays that followed. On Monday, April 2, 1990, the Nikkei fell almost1,938 points, or 6.59%, to close at 28,002. The decline came on top of
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a 3.4% loss the previous Friday. The apparent trigger for the secondlargest daily decline in stock prices was concern that major institutional investors would start selling stocks. 20 The low for the Nikkei225 for 1990 was 20,221.90, and it closed the year at 23,848.70. Howmuch of the decline should be attributed to the deflation of the bubble in Japanese stock prices is difficult to ascertain. In any case, theJapanese economy entered an extended downturn, and the Nikkei225 stock index reached a low of 7607.88 at one point during 2003.The decline of the Japanese stock market during 19