the first week in October.Some portfolio insurance was sold on that drop, and things seemed to beworking fairly well, as intended.The first sign that things might be getting dicey was a 92-point, one-daydrop on October 6. However, the market seemed to weather that; and,although it slid some over the next week, there was actually a good rally onTuesday, October 13, when the market was up over 70 points at middayand managed to close nearly 40 points higher, at just over 2,500. Again,the decline was orderly enough for most of the portfolio insurance to besold, although rumors were circulating that some portfolio managers were
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now becoming traders and hadn’t sold all the futures that they were supposed to. They were waiting for a further rally back toward 2,600. Thatrally never came (not for a couple of years, anyway).Trouble began on Wednesday, Thursday, and Friday, October 14through 16. The market was down 96, 57, and 109 points, respectively, onthose three days. The swiftness of the decline left the portfolio insurancemanagers gasping for breath. They did not sell the required number offutures for two reasons: (1) the decline was so fast that it was almost impossible to sell that many futures in so short a time, and (2) the futures weretrading at discounts to fair value, a fact not accounted for in the theory ofthe strategy. Thus, some of the portfolio managers did nothing (with theexception of praying, perhaps). To their dismay, their stocks were losinghuge chunks of value; and they were not getting the protection that theyhad theorized from their short futures, since they were not short nearly asmany futures as they were supposed to be.Monday, October 19, only made the problem worse. The marketgapped down 200 points right on the opening, and the portfolio insurance crowd hoped against hope for a reflex rally. When that rally did notmaterialize by about noon, they decided that they had to catch up on theirfutures selling and at least hold the losses to their current levels (the Dowwas now just over the 2,000 level). So they waded in and sold futures . . .and sold futures . . . and sold even more futures. They were selling futuresat 15.00 points discount to parity (forget fair value; forget theory; just sellthe required number of futures!). Many professionals who were long stockrealized that they could sell their long stocks and buy futures and lock in 15points, so they did that. This added more selling pressure to the market,which continued to collapse until it finished off 508 points on that fatefulday.
Obviously, there was plenty of natural selling in the stock market on the days leading up to, and including, October 19. But theportfolio insurance strategy exacerbated the decline to disastrousproportions. No one knows the exact extent to which portfolioinsurance contributed to the debacle, but it was substantial. Notonly that, the institutions practicing the strategy got hammeredanyway, as they never did get their protection properly in place. Inaddition, they became the subject of derision from Wall Street; government investigations were initiated; and, in general, things werevery uncomfortable.
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This fiasco pretty much ended the strategy of portfolio insuranceas practiced with index futures. Two new measures that came out ofthe government investigation were that index futures trading limits beinstalled and that futures halt trading at various points if the DowJones Industrials should rise or fall too far, too fast. These rulechanges effectively wiped out the portfolio insurance strategy usingfutures, for no money manager could ever trust that he would be ableto sell his futures when he wanted to, even if he religiously followedthe strategy to the letter. If the futures were locked limit down or ifthey weren’t available for trading, then he would never be able to sellthe required number of futures.
Program TradingToday, portfolio insurance is conducted with put options, whichbrings its own brand of problems. We discuss that strategy using putsshortly. First, however, let’s touch on the third use of futures as ahedge to a stock portfolio, program trading. This term is the catchallfor all forms of computer-generated buy or sell programs that enterthe marketplace. You often hear the financial media blame a marketdecline on “sell programs” or credit “buy programs” for a marketadvance. In reality, many of those “programs” are index arbitrage,but the media don’t make the distinction.To professional traders who hedge stocks with futures, programtrading has a distinctly different definition from index arbitrage. Thename originally came from the functions provided by block desks tohedge themselves (or their customers) while large stock orders, orprograms, were executed. A large customer might call one of thelarger trading houses and give an order to buy millions of dollarsworth of stock, say, by the close of trading. Usually, there is somesort of price level at which the trading house attempts to fill theorder; otherwise, the client could pay up wildly for the stocks. If thetrading house actually has to pay more for the stocks, it still givesthe execution to the client at the client’s price and takes a loss for thedifference in the house’s error account.Since these trading houses are not in the business of losingmoney, they will often hedge themselves by buying some futures
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while also buying the stocks. Then, if the stock buying forces theoverall market too high and they are looking at losses in order to satisfy the customer’s prices, at least they will have some profit from thefutures to offset those losses.Suppose a large customer calls a major trading house and says that he has$30 million worth of stock to buy and that there are about 200 stocks thatcomprise the order. In order to get the order, the trading house may tell thecustomer that he can get the best execution through them, because they willguarantee the prices at the time that the order is received.Now, obviously, the trading firm can’t really do that without takingsome risk, but they will risk a little in order to get the customer’s business. Ifthey decide that the 200 stocks behave in a manner that is essentially thesame as the S&P 500, they might buy S&P 500 futures as a hedge. Thirtymillion dollars is about 200 futures contracts if the futures are trading at aprice near 600.So the trading firm buys 200 futures and then sets about buying thestocks. If they have to pay more for the stock than the price they promisedthe customer, that will be a cost of doing business. However, that cost is offset by a similar profit in the futures. As the stocks are bought, the futures aresold out.
Note that the futures and the stocks are both being bought in thiscase. The futures are sold out when their hedging function is nolonger needed. When these programs are executed, the marketjumps, the futures often get large premium, and index arbitrage maybe a by-product. Also, the TICKI Indicator, which we mentioned earlier, usually registers a high number (over +22) as well.Because analytic methods have become more sophisticated, ithas become possible for clients and traders to determine how manyindex futures, and which index futures, are best used to simulatealmost any diverse portfolio of common stocks. This has allowedtrading houses to be very competitive in their business, for those withbetter hedging techniques can offer an institutional client betterprices (whether buying or selling). Thus, the larger institutions willoften show a program out for bids before deciding which tradinghouse gets the order. The institution has to be rather secretive about
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the actual details of the portfolio, however, or else the informationwould be leaked all over Wall Street.So, program trading is a more general term that describes themachinations involved in these institutional buy or sell orders. Theentire process works in reverse when large quantities of stock arebeing sold; the trading houses will sell futures to hedge their riskwhile they execute the client’s sell order. In some cases, the tradinghouse may be able to execute the order for the client (probably vialoading it into a computer and letting the computer generate orders)without using futures at all. This would still qualify as a buy programor a sell program, even though the general public and the mediaassociate futures with programs.In summary, these three strategies—index arbitrage, portfolioinsurance, and program trading—are ways in which large tradershedge portfolios of stocks with index futures. When the strategies areinitially executed, there is a short-term effect on the stock market, asit accelerates up or down, depending on whether stocks are beingbought or sold as part of the strategy. In general, however, this effectis short-lived and the market quickly returns to an equilibrium state.
THE EFFECT OF INDEX FUTURESAND INDEX OPTION EXPIRATIONON THE STOCK MARKETAs long as we’re discussing the effect that futures have on the stockmarket, we might as well address a related topic: their effect at expiration. Sometimes, expiring options and futures have a rather largeinfluence on the market. This effect used to be limited mostly to expiration day itself, but in recent years it has expanded to the pointwhere there may be an effect at certain times preceding and following expiration also.The reason that there is a noticeable expiration effect is relatedto the fact that the index futures and options settle for cash, while thecommon stocks that are used to hedge them settle for actual sharesof stock. Thus, even if the position is a perfectly hedged arbitrage
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position, only the stock side is traded at expiration—the futures automatically settle for cash without any trade taking place.Example: The final cash settlement price of the S&P 500 futures is determined, somewhat artificially, by using the opening price of each of the 500stocks in the index on expiration day (the third Friday of the expirationmonth). Suppose that an index arbitrageur has a perfectly hedged position,in which he is long all 500 of the stocks in the S&P 500 Cash Index in theirproper proportions and is simultaneously short enough S&P 500 futures inorder to perfectly hedge the stocks.If the arbitrageur decided to remove his position at expiration, all hewould have to do would be to sell each stock at its opening price on expiration day (he uses “market on open” sell orders). By definition, if each stockwere sold on the opening, the eventual price that he received for selling hisstock portfolio would be exactly the same as the cash settlement price of theS&P 500 futures. Thus, he would remove his arbitrage at parity, receivingthe same price for both his long side (stocks) and his short side (futures).The by-product of having executed the removal of this completelyhedged arbitrage position, however, is that a lot of stock is sold. Thus, thestock market would be down on the opening, for no reason other thanindex arbitrageurs were removing positions.
Where index options are concerned, the position is slightly different, but the result is the same. If you owned all 100 of the S&P 100Index (OEX) stocks in their proper proportion, your hedge would beshort OEX calls and long OEX puts, where both the puts and thecalls have the same terms (same expiration date and striking price).From the discussion at the beginning of this chapter, you know thatbeing short the calls and long the puts is equivalent to being shortOEX itself. So, in effect, the OEX arbitrageur in this case is long thephysical OEX stocks and is short the equivalent of OEX, or, as it iscommonly called, an “equivalent futures position" (EFP).The “artificial” effect that the index expiration has on the stockmarket has bothered (and still does bother) some investors, mostlythose who don’t trade derivatives; and they are usually only botheredif the market is driven down artificially. If the arbs are short stock andlong futures, then they must buy stock to remove their positions,
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which forces the market higher at expiration and is normally okaywith the critics.Note that arbitrageurs don’t have to remove their position atexpiration. Instead, they might roll their futures or options out to thenext month. If they do this, then of course, that has zero effect onthe stock market because no physical stocks are bought or sold. Thearbitrageurs make an economic determination, based on dividends,interest rates, and the prices of the respective futures or options, inorder to decide whether to remove the position at expiration or toroll it out to an ensuing expiration month.A little history of how the S&P futures expiration has evolvedover the years might be useful. Initially, S&P 500 futures settled atthe close of trading on that third Friday, expiration day. This createdrather wide swings because the New York Stock Exchange (NYSE)specialist was being bombarded with large sell orders (for example) atwhat is generally an illiquid time—late Friday afternoon. Moreover,OEX arbitrage was also sizable and was being unwound at the sametime, generally in the same direction.In order to dampen the expiration effect, the S&P 500 contractsand many other futures and option contracts were switched to opening settlement. Opening settlement is what was described in theprevious example, where the opening price of each stock is used todetermine the actual cash settlement price. (Note: when a futures oroption contract has opening settlement on Friday morning, then thelast trades in the contracts themselves take place at the close of trading on Thursday night—they do not trade on Friday morning.) Bydoing things this way, the specialist can attempt to round up largeinstitutions and brokerage firms to help him with the trade; if a largequantity of stock is being sold by an arbitrageur, the specialist may beable to find several institutions willing to buy part of that block ofstock. This might delay the opening of the stock, but it generallyallows for less of a gap opening and, therefore, less of an effect onthe overall stock market itself.
In reality, the perception for arbitrage to have a large effect on the stockmarket was always larger than any actual effect. The movements on the
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expiration Fridays during the mid- to late 1980s are listed below. You cansee that there was never any huge effect on the quarterly expirations, whenthe S&P 500 futures expired:Date
Dow Change
% Change
Date
Dow Change
% Change
9/8312/833/846/849/8412/843/856/859/8512/853/866/86
+10+6+17–11–21–5–13+25–90–3624
0.80.51.4–1.0–1.7–0.4–1.01.9–0.70.0–2.01.3
9/8612/863/876/879/8712/873/886/889/8812/883/896/89
–12+16+34+12+27+51+1+10+6+17–48+6
–0.70.81.50.51.12.60.00.50.30.8–2.10.2
The opening settlement went into effect for the December 1987 expiration. You can see that the two biggest moves on the chart occurred afterthe opening settlement was created, so it is debatable whether it helps much.In theory, however, it does; and it is certainly here to stay, at least as far asthe S&P 500 futures are concerned. By the way, if you look at the monthlyexpirations between the quarterly expiration, which are predominantly influenced by OEX, you will find even less volatility in general (the one exceptionbeing October of 1987, of course—but what happened that day [down 109points] was far greater than any expiration effect of OEX options).
Most other index futures and index options use an opening settlement as well. The main exception is the OEX Index options, whichcontinue to use a closing settlement. This is mostly due to the factthat the Chicago Board Options Exchange (CBOE—where theoptions trade) is reluctant to tamper with a highly successful contract,which is certainly a valid point.
Games People PlayIf you were able to discern, in advance, what the intentions of thearbitrageurs were and how much stock they had to buy or sell, then
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you could make a nice little trade for yourself. That is, if you knewthat the OEX arbs were going to buy a lot of stock at the close oftrading on expiration, then you could wait until about 3:30 P.M. Eastern time and buy OEX in- or at-the-money calls, expiring that day.When the arbs bought stock to unwind their positions and therebyforced OEX quickly higher, you would profit.Since things are never that easy on Wall Street, you might correctly suspect that it is not an easy matter to find out what the arbsintend to do at any expiration. However, because of the fast potential rewards, it is an endeavor that many traders undertake, trying topredict the stock market’s movement as affected by expirationunwinding of arbitrage positions. It is my opinion that the best indexto use for this type of short-term trading is OEX, as the moves occurat the end of the day. On the other hand, if you attempt to play theS&P 500 expiration, you must hold a position overnight from Thursday night to the opening on Friday morning (recall that SPX is opening settlement on Friday morning, but there is no trading of SPXoptions or S&P 500 futures after Thursday’s close). Too many thingscan happen overnight, especially since many government statisticsare released prior to the opening on a Friday. Such nonexpirationfactors can affect the expiration, so I feel you’re better off trying totrade the OEX expiration.If you’re going to trade the expiration, but not as an arbitrageur,the three things you should attempt to determine are (1) whether thearbs are long or short stock coming into the expiration, (2) if they aregoing to unwind their positions or are going to roll them, and (3)what the open interest in in-the-money OEX calls looks like. It turnsout that a good floor source can give you the best information on thefirst two. The reason that this is true is that the arbs will alwaysattempt to roll their position out to the next expiration month if theycan; it is a lot of work to establish these arbitrage positions (whether100 or 500 stocks are involved), so it’s a lot easier for the arbs if theycan keep their stocks and merely roll their options. But they will onlyexecute the roll at a price that is favorable to them; if they can’t gettheir price, then they’ll unwind the position at expiration and look toreestablish it at some later date.The reason floor brokers are of great help is that spread brokersin the OEX pit can see how the arbs are bidding for the “rolls.” That
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is, they can see if the arbs are attempting to roll a long call/short putposition or are trying to do the opposite. If the arbs are attempting toroll a long call/short put position, then the arbs must be short stock.Therefore, there is potential buying power at expiration. In addition,spread brokers can tell whether the “rolls” are actually being tradedor are just being bid for. If they are actually trading, that lessens thepotential expiration effect.In April 1995, there was a large arbitrage position. The market had been inthe midst of a strong bull run, and there was huge open interest in OEXcalls, indicating a large OEX arbitrage position. Floor sources told us thatthe arbs were attempting to roll long calls out to May or June expiration, soit was apparent that the arbs held short stock positions hedged by longcall/short put option positions. These facts were known more than a weekprior to expiration, and seemed to be fairly common knowledge amongprofessional traders.Moreover, as expiration approached, there was very little actual tradingof the rolls. Open interest was remaining fairly constant in the OEX Aprilcalls, and floor traders did not see many rolls being executed. This emboldened traders; and by Thursday afternoon of expiration week, it was becoming obvious that there just wasn’t enough time or supply for the arbs to beable to roll. Therefore, there was going to be rather massive buying ofstocks in the OEX Index at the close of trading on Friday.The buying actually started on Thursday (more about that strategylater), when the market reversed from a moderate down day to close up 23on Thursday. Friday saw another 40 points tacked on, with the majority ofit coming late as the buy programs were executed. Traders who had donethe analysis of the arbs’ position made very good profits in short-term OEXcalls, as OEX rose over 7 points.
You can see from this example that foreknowledge of the arbs’positions and their subsequent handling of those positions as expiration approaches can produce a profitable speculative trade. Don’t bedismayed if you don’t know floor sources—it may be possible toglean similar information from your brokerage firm’s option department, as they talk to floor traders. Also, since the advent of CNBC’smore advanced coverage of the day-to-day aspects of trading, youcan often get the opinion on TV of some of the more “connected”floor traders.
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Open Interest ImplicationsIt is important to understand that it is not necessarily easy to discernthis information regarding arbitrage positions. Some of the arbs evengo so far as to leak incorrect information about their positions. Thebest that an outside observer can do is to put together enough information to make an educated guess; if the guess is good enough,the rewards will be ample. There are certain basic facts that areirrefutable and will help anyone determine what is going on. Oneimportant guide is open interest of OEX options. As expirationapproaches, public customers tend to sell in-the-money options andhold at- or out-of-the-money options. Those in-the-money optionsare predominantly in the hands of arbitrageurs by expiration. Thus, ifyou observe the day-to-day changes of open interest of in-the-moneyoptions as expiration approaches, you can get a “feel” for how muchbuying or selling power remains in the market.June 1995 expiration was a fairly good example of how open interest provided clues beyond the information that was generally available. It was fairlycommon knowledge that the arbs were once again short stock, hedged bylong calls and short puts. Also, the market had rallied to new highs at 510during the previous month, so most of the OEX calls were in-the-money asexpiration drew near.On Wednesday morning of expiration week, open interest in the callswith strikes from 440 (the lowest strike) through 505 totaled almost130,000 contracts. On Wednesday night, at the close of trading, 40,000contracts were exercised. This early exercise was announced on TV andwas pretty much common knowledge. Exercise figures are available on anygiven day from the Option Clearing Corporation in Chicago. On Thursdayevening, another 46,000 contracts were exercised. Again, this early exercise was widely broadcast on TV.At this point, many analysts, having seen two days of early exercises,felt that there wasn’t enough firepower left for expiration. They felt thatexpiration day itself would be a dull one. However, that was not the case atall. Most of the open interest had not been rolled out to later months, sothere were still 44,000 in-the-money calls that represented buying power.In fact, it turned out to be good buying power as OEX meandered slightlyhigher most of expiration day and then spurted on the closing buy programto finish over three points higher on the day.
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Although static numbers are subject to change, I find that anopen interest of 40,000 to 50,000 in-the-money contracts is sufficient to cause a market move of at least 1.00 OEX or S&P point atexpiration or at the close of trading on one of the days immediatelypreceding expiration. Of course, at many expirations the open interest is far greater than that, and larger moves can occur.Open interest can therefore be a valuable guide to what is happening at expiration. Always check it as a backup to whatever “stories” you are hearing, for it is a reliable indicator. Unfortunately, it isonly published once a day (before the market opens), so you can’t tellif it is changing during the day. That is where floor sources can comein handy. For example, if you know open interest is large enteringexpiration day, but your floor sources tell you that the arbs are rollingtheir positions out to the next expiration month, then you wouldhave to modify your plans, since the effect of the arbs on the closingwould be reduced or eliminated. You should always expect a numberof positions to be rolled on expiration day itself; some arbs would justrather keep their stock positions in place at almost any cost. However, as a rule of thumb, if there is an open interest of at least40,000 in-the-money contracts as the day begins, you have a goodshot at having enough program activity to be able to make a profitable trade.A few other important points should be made. If there is40,000 open interest in in-the-money puts, then sell programsare possible. So you should really net out the open interestbetween the in-the-money calls and the in-the-money puts. Overthe years, buy programs at expiration have been far more prevalent than sell programs, but be mindful of the possibility of a sell.You need to monitor the in-the-money put open interest for thatpurpose.As expiration day itself approaches, the largest open interest willprobably be in the at-the-money strike (or perhaps two strikes, ifOEX is right between two of them). This open interest can be critical,for it might tilt the balance between buys and sell, depending on theway the market moves; or it might add enough additional ammunition to push the open interest total from below 40,000 to over40,000, thus creating a tradeable situation.
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Suppose that OEX is trading at 579 as expiration Friday begins and that thetotal open interest of all in-the-money calls up through the 575 strike is35,000 contracts. Moreover, the open interest of all in-the-money putsdown through the 585 strike is 25,000 contracts. On the surface, it appearsthat this expiration will not offer much in the way of a trading opportunity,because there is only a net of 10,000 contracts on the buy side.However, when we look at the expiring 580 calls, we see that openinterest is 40,000 contracts. At the beginning of the day, most of that openinterest is probably in the hands of customers. However, if OEX were to riseand be above 580 by the end of the day, a large portion of that open interest could pass from customers’ hands into the hands of arbitrageurs. In turn,that would mean, also, that there was net of 50,000 in-the-money contractson the call side, and therefore buy programs might be possible at the closeof trading.
A Hedged StrategyWe’re going to spend more time discussing the arbs’ actions, but firstwe want to give you a strategy that is a hedge, but that can still makesome nice money for you on expiration day. Obviously, if you havethe arbs’ intentions pegged exactly right, you can just buy someexpiring OEX calls and make money. But there are a number ofthings that can go wrong, even if you have done your homework correctly. First of all, the market may have an interim adverse movebefore the arbs swing into action. Just because there is going to bebuying on the close, for example, it does not mean that the market will be up for the day. Some speculators hear that there is goingto a buy program on the close, and they look for an entry point allday long in order to buy the market. This could mean that you havebought the wrong calls or that you lose money on your call eventhough you had things figured out correctly.In May 1995 there was a fairly large arbitrage position that once again consisted of the arbs being short stock, hedged by the long call/short put position. Expectations were high that the arbs were actually going to buy theirstock a day early, on Thursday night. Speculators who had this figured out
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waited until about 3:30 P.M. on Thursday to buy calls on OEX, expectingthe arbs to begin forcing the market higher shortly thereafter.However, at the same time, the news media were interviewing a FederalReserve System (Fed) governor who made some bearish comments regarding the future of interest rates. As a result, the bond market and then thestock market got slammed.At the close, there was a small buy program, followed by a rather largeexercise of OEX calls by the arbs, but it came too late for those who hadbought calls before the Fed governor’s remarks.
This example shows the frustrations that can accompany theunhedged OEX call buyer who is attempting to figure out what thearbs are going to do. He might be right, but he might not makemoney. There is another strategy—a hedged strategy—that can helpprevent losses like that, while still allowing for profits to be made. Forexample, if you are approaching expiration as a strategist, and notas a speculator, then you would take the following position on expiration Friday, if you expected the arbs to execute buy programs onthe close:Buy five in-the-money expiring OEX calls.Sell one S&P 500 near-term futures contract as a hedge.Note that the S&P 500 contract is never expiring that Friday (theold contract may have expired that morning, but the currently trading S&P 500 contract always has at least one month remaining untilexpiration, and sometimes as many as three months). The reason weuse five OEX calls and only one S&P 500 future is that OEX optionsare worth $100 per point, while S&P 500 options are worth $250per point. In addition, OEX trades at about half the price of the S&P500. In essence, this is a complete hedge—all stock movements areaccounted for, except for the difference in movement of OEX versusSPX (the S&P 500 Cash Index). That’s what we’re looking for—forOEX to outperform the S&P 500 on the close.The margin required for this strategy is that both sides must befully margined, even though they are obviously hedged. Until crossmargining becomes a reality, you must pay for the calls in full andalso margin the S&P futures.
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Example: The February 1992 expiration was a classic example of how thisstrategy worked well as a hedged vehicle. After the market opened and stabilized, these prices were available:OEX: 386.02OEX Feb 380 call: 61⁄2S&P March future: 413.30The hedged strategy was established by buying five of the OEX Feb 380in-the-money calls that were due to expire that evening, and they werehedged with the sale of an S&P March future (the nearest term futures contract). Note that the OEX calls have a slight premium, because traders areexpecting a buy program. The premium on OEX calls, as expiration nears,is often a “tip” as to how OEX market makers view the upcoming expiration. If the in-the-m