Futures shock.

• Author: Waldman, Steven
• Position: Includes related article about stock index futures market

FUTURES SHOCK

Recent press reports have blamed thevolatility in the stock market on stock index futures and options. Traders bristle at the suggestion, arguing that the market behaves wildly because of "market fundamentals," not because some financial tool is forcing it to. "It's like the National Rifle Association says about guns," explains market analyst Jeffrey Miller, referring to the lobby's motto that guns don't kill, peole do. "Stock index futures just make it easier for the market to do what it wants to."

Unfortunately, his analogy is perfect. Futuresand options may not force the market down when it wants to go up, but they do seem to make it more likely that the trips downward will be dangerous.

The standard definition of a future is simple:a contract to purchase a commodity, such as corn or hogs, at a given price and time in the future. With stock index futures, which were first traded in 1982, the "commodity" is a bundle of stocks. The value of the Standard & Poors stock index futures contract, for example, rises and falls according to the price movement of 500 different stocks. The only difference between pork belly futures and stock index futures, then, is that in the first case if something goes very wrong, the nation could suffer a bacon shortage, in the second, a financial collapse.

Occasionally, warnings are heard in the newsabout stock index futures and their relationship to computerized "program trading," usually when the stock market's euphoria is interrupted by a brief plunge, like the 116-point dive it took in 71 minutes on January 23. But mostly the din of Wall Street's partying had drowned out complaints that these might also lead to serious trouble.

That's unfortunate because some of thosewarning of trouble are in a position to know. On December 11, as the stock market entered the final turn in its wind sprint toward 2,000, John Phelan, chairman of the New York Stock Exchange, suggested that stock index futures, in combination with certain recent trading strategies, might cause the market to experience a "meltdown." "Two years ago, I would have said no," Phelan told a meeting of Gannett Newspaper editors. "Now I think it could happen.c The next day he said he was thinking along the lines of a 600-point drop, adding, "A Boesky can undermine the credibility of teh market. This type of trading...can destroy the market."

Some New York Stock Exchange officials agreewith futures advocates that these new instruments help the stock market in many ways and may even be partly responsible for its rapid growth. At the same time, the officials warn, the possibility that they might also contribute to a meltdown is worth taking seriously.

A 600-point drop wouldn't necessarily lead toa great depression, but in percentage terms it would be more than twice the size of the drop on October 28, 1929. It would mean that on average the price value of stocks would decrease by close to 30 percent. The value of pension funds could drop, companies might have to lay off workers for lack of modernization capital, banks might be destabilized because their investment portfolios or too many of their customers were injured in the stock market, and, in general, pessimism would guide economic decisions.

Sleeping better

The frenzy of people screaming hysterically ateach other in the futures trading pit has its origins in Renaissance Europe, at trade fairs where merchants and customers would meet and agree on purchases of products coming through town later. Despite being frequ ently compared to legalized gambling, futures trading does serve some important economic functions; in the U.S., it grew out of the desire of midwestern farmers to have a way of selling their produce with some certainty of the price.

Take the case of a grain elevator operator whofears that the price of his corn will drop before it can be sold, perhaps becau se of a larger than expected corn crop. He sells a futures contract in corn and locks in the price he will be paid, "hedging" against unpredictable market shifts. The purchaser might be a processor like General Foods, which fears that prices are going to rise and wants to preserve a low price. Or it may be a speculator whose interest is making money by betting the price of corn is going to go higher than the futures price.

In the late seventies, trade began on financialfutures, including contracts for products such as deutsche marks, Treasury bills, bonds and government-backed mortgages. During the Carter...