Opinions of trading futures are split between those on the inside who use them and those on the outside who fear them. For security futures to deliver on their highly touted potential asrevolutionary products, prospective users must understand the purpose of futures products first.<\/p>\n
Regardless of whether you believe the launch of security futures products (SFP) has been a great success, a complete failure, disappointing or promising they are not where the exchanges offering them – OneChicago and Nasdaq Liffe Markets (NQLX) – want them to be. To gain the market share that many believe is possible, the public must overcome some preconceived notions about futures. Education seems to be the answer.<\/p>\n
Representatives of OneChicago and NQLX are educating potential users of the benefits of SFPs through road show presentations, Web- based initiatives and one-on-one visits with prospective users, hopefully slaying negative stereotypes of futures trading in the process. How products created primarily to transfer risk gained such a reputation as being the ultimate gamble doesn’t really matter. What matters is that for SFPs to reach their potential, the huge pool of investors who have equity market risk must learn that futures can be used (and historically have been created to manage that risk.<\/p>\n
“I find the idea that futures are ‘inherently dangerous’ as preposterous,” says NQLX Chairman Tom Ascher. “Risk and risk transferal are what derivatives are about. We are in the risk management and risk transferal business.”<\/p>\n
While many have blamed a weak equity market for the perceived sluggish start to single stock futures, that weakness should go a long way in demonstrating the need to offset naked equity exposure. But the equities markets are not merely suffering from a bear cycle but from a lack of confidence in the integrity of the entire structure. Whether it is companies reporting creative earning figures or investment banks putting out faulty analysis to increase their IPO business, the markets have suffered a black eye that not only helped to push the market lower but has caused trading volume to drop as well.<\/p>\n
Commodity Futures Trading Commission Chairman James Newsome recently noted that SFP volume compares favorably to similar launches of new products and has done so in an extremely difficult environment. “With regard to their performance, all I can say is that it is hard to imagine a more difficult time to launch a new product, and the volume that they are doing – given everything that is going on in the economy – is amazing,” Newsome says.<\/p>\n
June brought encouraging news as both OneChicago and NQLX set volume and open interest records. June 5, OneChicago traded 106,633 SFPs, more than quadrupling its previous record.<\/p>\n
Russell Wasendorf, chairman of futures commission merchant Peregrine Financial Group, was among those who thought SFPs would not only be a success but could garner significant volume early on. Wasendorf acknowledges he was a bit premature and notes that the slow start may have been a blessing because they were not as prepared to trade the new instruments as they thought.<\/p>\n
The reason for his early optimism was the rapid increase in the number of E-mini traders. He believes, however, that retail E-mini traders will wait for a bull market despite their recent efficiency shorting the mini products. They are a little more cautious trading individual stocks from the short side, Wasendorf says.<\/p>\n
He has found that the learning curve for the retail trader has been steeper than he initially envisioned. “It has taken more resources to get them up to speed,” Wasendorf says. Though interest is growing across the board, the most significant interest is coming from the institutional side, Wasendorf adds.<\/p>\n
WHO IS GOING TO BE FIRST?<\/p>\n
The test of any new market is getting that initial volume to create a comfort level for others to follow. But because these are hybrid products – both a futures and a security – the question is who is going to trade them? Or more to the point, who is going to trade them first? Initially there has been more interest from the futures side but the natural users of any futures contract are the people who have exposure in the underlying cash instrument. Seeing that these are futures on securities, that would be the securities world.<\/p>\n
“We all know that the key to making this market explode is to get into the equities market and it just unfortunately takes time,” says Perry Dahm, who has been producing a newsletter on stock futures since 2001. “The trick is the individual. Anywhere from 750,000 to 1 million people are trading futures and you go to the securities industry and they have 27 million accounts. You don’t have to think about it very long to figure we need to be in the securities market to really make this thing take off,” Dahm says.<\/p>\n
Of course potential is just that, potential. The exchanges are trying to reach every prospective user to reach that magical critical mass.<\/p>\n
“My primary target is everyone,” says OneChicago Managing Director Peter Borish. “I am not that smart; I wish I knew who [will trade] to say I have this many bullets in my gun and I am going to point at you and you are the guy who is going to trade. Unfortunately, I have to take a wider swath.”<\/p>\n
Asher notes that “Critical mass is the result of multiple parties going from sticking their toes in the water to actually wading in the water. It is a bit of a chicken and egg because we do have a lot of people who watch the market and see the relevance of the product and see what it can do but they want to see other people do it first.”<\/p>\n
ONE WHO TOOK THE PLUNGE<\/p>\n
Ed Durkee, managing director of Athena Risk Advisors, has been creating overlay programs to cut volatility and increase alpha in traditional stock and bond portfolios for institutional investors for 15 years. He believes that single stock futures provide a great opportunity to expand on his overlay programs by adding efficiencies from the reduced margin of SFPs to his overlays and has a pilot program to create overlays using single stock futures.<\/p>\n
Durkee will take a portion of an institution’s equity exposure, transfer it into futures and apply the margin savings to an overlay consisting of a pool of managed futures programs. This reduces the overall volatility and adds performance. His customers are small institutions that want alternatives to long cash positions or more traditional hedges. The strategy allows him to enter the market slowly and doesn’t require him to trade it actively, which he says he couldn’t do with present volume. “We very carefully assemble positions but to really have fun with this thing you need to be able to do size,” Durkee says.<\/p>\n
Athena’s customers see it as an efficient alternative to holding stock and believe if liquidity develops the market can be huge. “Not just for us but other people who are trying different sorts of alternatives strategies to holding stocks, which is pretty stupid when you think about it,” Durkee says.<\/p>\n
The lack of volume is the only thing holding Durkee back from creating single stock overlays on a greater scale. “If it were a bigger market, we would be doing more with it. I think it is a really interesting product; I don’t know why everyone else doesn’t,” Durkee says.<\/p>\n
GROWING PAINS<\/p>\n
Perhaps he is ahead of the pack because he embraces the risk management benefits of it. “Looking at it rationally, if you forget about it as a speculative device and just look at it as a risk control device, it’s great. It is so efficient compared to trying to use just securities. If what people want to do is protect themselves against volatility and they are worried about the stock market going down, this is the ideal tool,” Durkee adds.<\/p>\n
SURPRISES<\/p>\n
If there has been any pleasant surprises since the launch of SFPs it is the success of futures on exchange-traded funds (ETFs). OneChicago’s Diamond ETF futures and NQLX’s Russell 2000 I-share ETF futures have been consistent volume producers.<\/p>\n
Borish has described SFPs as a three-legged stool consisting of single stock futures, narrow-based indexes (NBIs) and ETF futures. Futures on ETFs have been the most consistent contracts for both OneChicago and NQLX. That being the case the biggest disappointment so far is the lack of volume on NQLX’s QQQ futures (futures on the Nasdaq 100 ETF). The QQQ is the undisputed king of the ETF world and seeing that it trades the most volume of any security, was the product that held out the most potential of success with the launch of SFPs. While Ascher acknowledges that the QQQ futures’ lack of volume is somewhat of a surprise, he still believes it will be a winner and thinks its initial weakness is a product of the success of the underlying, “We believe as fervently as ever in the potential of future on the QQQ but we have a higher standard to meet, the product is so liquid and so successful,” Ascher says.<\/p>\n
If futures on QQQs was NQLX’s ace going into the launch, OneChicago held out great hope for their NBIs. Regulatory wrangling over speculative position limits and changes in their initial physical delivery structure has delayed the launch, but on June 5 OneChicago along with Dow Jones Indexes announced a licensing agreement enabling OneChicago to list futures on 15 Dow Jones MicroSector Indexes. The products were developed jointly and are similar in composition to those initially proposed by OneChicago.<\/p>\n
OneChicago had presented its NBIs before its entire list of single stock fut\\ures and many potential users of SFPs indicated greater interest in the indexes than the actual single stocks. “Getting NBIs up and running is important because that is the third leg of the stool, which we have not been able to put down,” Borish says. It is important because they will bring in additional users who will then have access to the entire market. “That is going to be a good incentive to push people over the edge to [get connected],” Borish says.<\/p>\n
Dahm believes that the introduction of NBIs will increase volume and lead more hedge funds to take the plunge. “From day one we are going to see some big improvement in market liquidity,” Dahm says.<\/p>\n
NQLX has taken a wait and see attitude on NBIs and has no products in the pipeline. “Right now it is something we keep an eye on but are not in the process of constructing products,” Ascher says.<\/p>\n
BROKER\/DEALER APATHY<\/p>\n
Though both exchanges are working diligently to educate possible users, there is evidence that those efforts are not filtering down to individual traders. Shortly after launch Dahm sent a survey to 40 discount equity broker\/dealers and only one was preparing to trade SFPs. More than half indicated no knowledge of the products whatsoever.<\/p>\n
“The product was made with the individual investor in mind and unfortunately that is the guy who is not getting the information or the availability to trade. I don’t know of one single broker\/dealer right this minute where you can go to and open an account. I know some that are talking about it, but I don’t know anybody who will let you do it right now,” Dahm says.<\/p>\n
Learning about and marketing new products takes time and money and that is where the weak equity market hurts SFPs. Broker\/dealers will not embrace SFPs until they are convinced it is in their best interest. “People are not going to go out there and spend money on spec to do new things. This has to be customer driven and that is where we are focusing and that is having some traction,” Borish says.<\/p>\n
Asher adds: “Retail equity brokerage firms have not yet accepted the products and may have to be pushed over some invisible barrier to embrace the product and that may take some time.”<\/p>\n
Resistance from the broker dealer community has been linked to fear it could eat into other business despite evidence that new markets tend to increase volume across the board. Ascher does not dabble in conspiracy theories but acknowledges that fear of competition may be holding back acceptance of SFPs. “I would say that there are some parties – that in defending their own position and recognizing we may have a better solution – aren’t necessarily going to run to embrace the products,” Ascher says.<\/p>\n
Borish believes that the market’s benefits will bring users to it. “We have only been up six months and I have no doubt in the fact that you can get stuff done. It is cheaper, it is faster and it is more efficient,” Borish says.<\/p>\n
INSTITUTIONAL TRADERS<\/p>\n
The message both exchanges are sending to institutional traders is that when large orders come into the market, market makers have risen to the occasion and 1,000 plus lot orders are executed quickly with little slippage (See “Getting it done,” above).<\/p>\n
OneChicago and NQLX are targeting both the equity hedge fund world and commodity trading advisors. Borish says that one of the largest CTAs based on money under management is already trading on OneChicago, but most CTAs Futures interviewed have little interest. Besides the obvious concern over liquidity many managers view the contract size – 100 shares – as too small. “I don’t see much use for them unless they make the [contract size] a lot bigger,” says Hugh Yeakel, principal of Dorset Futures. Many CTAs expressed concern over contract size but Ascher notes that the pricing model they employ as well as volume discounts provided by many of their member firms will offset the disadvantages of the smaller contract.<\/p>\n
Of course liquidity is always brought up as the initial barrier but sufficient liquidity just gets a product in the door. For a hedge fund that trades the underlying security, once there is enough liquidity it would make sense to trade the futures, but for CTAs, liquidity is just the first step. They must test whether it would be profitable in their program and how it correlates to other markets.<\/p>\n
Campbell and Co., which operates both managed futures and long\/ short hedge funds, has not looked into using SFPs. “We only do research on projects that we think will bear immediate fruit and we just didn’t see this as being immediate,” says James Little, EVP at Campbell. Little does not rule using SFPs in the future but notes that when a firm is trading $4 billion plus, it has to make sure the markets traded are deep.<\/p>\n
One manager who is not burdened with billions to manage is Defender Capital Management President Jonathan Matte (see “Hot new CTAs,” October 2001). Matte plans to launch a program that will trade a basket of five SFPs by the end of the summer. Defender’s small size and relative low margin to equity ratio will allow them to trade the product despite low volume.<\/p>\n
Whoever gets to the market first, small or large CTAs, equity hedge funds or individual retail traders, enough of them have to come to the table for the larger universe to trade. Both exchanges believe that their market making models alone should provide that comfort and as soon as traders take that next step there will be an explosion of volume.<\/p>\n
“They are fearful of what I adoringly refer to as roach motel – they don’t want something that they can check into but not check out. We fervently believe that we are already there because of the nature of how our market makers work, but there is a show me crow out there who want to see the next wave of volume,” Ascher says.<\/p>\n
Borish puts it simpler, “You can get anything done on a bid or offer that you want to. You wouldn’t go in and say buy me 1,500 coffee [futures] at the market and you shouldn’t go in here and say the same thing, but on the other hand if you put 1,500 in any one of our stocks versus 1,500 coffee, I guarantee you would get it done faster in our market.”<\/p>\n
While many have expressed disappointment over the volume in SFPs, it would be good to remember that all new markets go through growing pains. Wasendorf notes that each time a new financial market is launched it does so with great expectations followed by slow growth.<\/p>\n
GETTING IT DONE<\/p>\n
Though overall volume has been unimpressive, when size orders come into the market there are market makers who will take the other side at the customers price.<\/p>\n
* 1,574 June 03 Oracle (ORCL1C) contracts filled at one price 5\/ 27<\/p>\n
* 1,956 June 03 Citigroup (C1C) contracts filled at customers single limit price 5\/28<\/p>\n
* 1,198 of 1,213 lot order of Tyco (TYCL1C) filled at one price (5\/28). 1,926 of 2,011 lot order traded at a customer’s single limit price (5\/29).<\/p>\n
* 1,019 June 03 GOLDMAN SACHS (GS1C) were filled at a customers single limit price. (5\/29)<\/p>\n
Examples of large orders executed at OneChicago over a one-week period.<\/p>\n
Copyright Futures Magazine Group Jul 2003<\/p>\n","protected":false},"excerpt":{"rendered":"
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