Like a New York taxi on a rainy day, liquidity disappears when it is needed most. Anyone will make you a market when volatility is low and price movements are small, but so what? Great athletes and national leaders are defined by what they do in the clutch, and it's high time we start holding our financial institutions to the same standard.
Economists, with their usual deaf ear for the double entendre, refer to such a disappearance-when-needed as "backward bending." It shows up on both the supply and demand sides. Take the never-ending political lamentations over Americans' low rate of personal savings. If the government really wants us to save more, it should remove such impediments as double taxation of dividends, limitations on contributions to retirement accounts, limited deductibility of losses and multiple holding periods for capital gains taxes.
To a large extent, saving is a fear-driven response. If we're confident of the future and if we're getting a high return on our existing savings, we feel less motivated to save an increasing percentage of our income. It's no accident that savings rates fell once the great bull market took off in 1982, and then plunged rapidly in the 1990s. The savings rate jumped in recent months, as the bear market left a sizable portion of our portfolios in the woods, as bears are wont to do.
The fear phenomenon helps explain why current exhortations for Americans to get out of the house and spend more will, by themselves, be ineffectual. More important, the present policy of low interest rates, designed to promote consumption, may contribute to an increased demand for saving. Portfolio incomes will fall with interest rates, so the quantity of savings must increase to maintain investment income. The opposite phenomenon -- lower savings in response to higher interest rates -- has been observed as well in a classic backward-bending response to policy goals.
Personal Savings vs. S&P 500 The Real Wealth Effect
Answering the Demand
While it's nice to be called a hero for stepping up in the clutch, it's far better to do a little advance planning to prevent crises. Financial markets exist largely as risk-transference and liquidity-provision mechanisms, so they should be designed to accommodate the inevitable wild markets and volatility surges. In the case of the forthcoming futures on single stocks (SSFs), what does this mean for the exchanges' product offerings?
First, SSFs have a massive advantage over alternative products in their ability to handle specific security risk, as opposed to general market, or systemic, risk. After all, if you want to adjust your risk exposure to
, then trade IBM futures, not
futures. This argues that the availability of SSFs should be a function, in part, of the specific risk for each security.
Second, we've all learned the hard way about preopening and after-hours stock volatility produced by government reports and earnings announcements, respectively. Liquidity has existed at these times for institutional traders with access to systems like Instinet, but individuals typically have had to wait for the opening bell. The wait isn't always pleasant. Exchanges can serve both themselves and their customers by meeting the demand to trade during these hours.
Third, the best place to measure volatility is the options market. If we view options as a form of insurance -- and we should -- then volatility represents the price that traders are willing to pay for a measure of certainty. High volatility indicates demand for risk protection, and it is the exchanges' job to answer this call.
Finally, exchanges need to remember a truism from the petroleum industry: The best place to look for oil is where you've already found it. Quite simply, there's no better indication of the market's demand for risk management and price discovery than existing trade volume.
The Proof Is in the Pudding
Will exchanges' attention to their customers' interests as defined above lead to successful SSF products? Empirical evidence suggests that combining these factors into a proprietary objective function can be confirmed by trading volume in individual equity options, the products most similar to SSFs. In fact, work done on behalf of the new
Nasdaq Liffe Markets
exchange, or NQLX, shows that combining the variables linked to customer demand is rewarded with exponentially accelerating volume.
Option Volume as Confirmation of NQLX Objective Function
Source: Howard Simons
Each green dot in this chart represents the intersection of rank and options volume for a stock. For this example, I selected 200 stocks from a universe made up of the
indices. As a stock moved up higher in the objective-function rank, its options volume increased at an accelerated exponential rate.
The implications of this objective function for SSFs' acceptance are astonishing. The very phenomena that produce backward-bending volume curves elsewhere, such as overnight and early-morning gaps, high volatility and a great deal of stock-specific risk, should actually increase demand for SSFs.
author John Naisbitt observed that people use a new technology only as an improvement on existing technology until a new generation realizes the technology's potential. Much of the early usage of personal computers, for example, was simply as a better typewriter and adding machine.
We have an opportunity to short-circuit this process in our adoption of SSFs by envisioning their uses and potential before they are introduced in the U.S. In the interests of full disclosure, I'm not a disinterested party in this topic, but rather am involved intimately in their development. I invite your
questions and comments as to how SSFs can help you do what you already do -- faster, cheaper and more efficiently.
Howard L. Simons is a senior vice president of product research at Nasdaq Liffe Markets, a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of
The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to
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