Got those Y2K butterflies? You aren't the only one, but yours could make money.
There's still time, folks, to take advantage of year-end panic or mispricings in the derivatives markets, including one dubbed the "Millenium Butterfly" by Chicago dealers, another in gold options and a third in index options.
Will the world fall apart when midnight strikes on Dec. 31, 1999? No one knows, but that doesn't mean you can't profit from doomsday worries. "The financial markets are very smart. If something's going wrong, somebody's going to know about it, and the market will account for that," said one derivatives trader in Chicago, which will be the vortex of much of the Y2K speculation in the U.S.
Talk about Y2K on our
There are two key elements to pretty much every Y2K trade: forward settlement (placing a bet that comes due on or right after January 2000), and fear (how a particular market will price in panic, and snap back when -- and if -- those fears come to nothing).
The first Y2K play we came across is fittingly known as Millenium Butterflies, short for the chart formation of the trade.
A butterfly trade really just involves several simultaneous trades that overlap each other. Essentially it is a spread -- a neutral position that's part bull and part bear. Butterflies can be costly in terms of commissions, since you're paying for three or even four trades, but can help limit risk.
Millenium butterflies are trades common in futures and option markets, according to Peter Barker, vice president of index products with the
Chicago Mercantile Exchange
. "Our traders have been doing these around here for a while now, to price in Y2K risk," he says.
What's popular is a butterfly position using
Standard & Poor's 500
index call options, explains Greg Simmons, manager of
index options hedge fund in Newport Beach, Calif. (A call option is a contract giving the owner the right to buy a stock -- or in this case, an S&P 500 index -- at a certain price and date in the future. A put option is the right to sell.)
Currently, the S&P 500 index, or SPX, is trading at 1254.1, but who knows where it will be come New Year's Eve.
Even the end of the world's got a price, and you can buy it by strapping on a butterfly trade. With the SPX now trading around 1254, Simmons says he would likely buy an SPX January call option with a 1300 strike price, sell two January 1325 calls and buy a final January 1350 call. Such SPX index options now can cost as much $3,000 apiece, so it's important to check margin requirements for such trades, Simmons says.
His Y2K rant? The
Securities and Exchange Commission
has yet to sign into effect easier margin rules for such butterfly trades. "As soon as they approve this change, you don't have to put up hundreds of thousands of dollars in margin. The SEC, by dragging their heels on these rule changes, which were approved by exchanges back in August, has hampered the end-of-year hedging available in the markets."
In eurodollar futures, "Millenium butterflies have been done in big size -- thousands, tens of thousands (of contracts) -- by mutual funds, hedge funds, big speculative players," says Barker. The big open secret? "They're done every year actually, it's just happening earlier and more often this year because of Y2K." (Eurodollars are U.S. currency held in banks outside the U.S., mainly in Europe. They pay a slightly higher interest rate than dollar deposits in the U.S.)
However, this Y2K eurodollar butterfly trade is obsolete, since it involved buying contracts spread across the calendar, from September through March. Buy a September 1999 futures contract, at the same time sell a December 1999; sell another December 1999 contract, at the same time buy a March 2000. (It's not possible to buy a September-dated option anymore.)
And of course, where there's danger, there's gold.
"We've seen tremendous buying over the last six months in call options on gold, particularly
call options expiring in November and December," says a
Credit Suisse First Boston
Gold last month shimmied up roughly $45 an ounce, lifting the
December gold futures contract to $311.50 from $267.80 in the space of a few days. The open position in December Comex options now represents call options on almost 6 million ounces worth of gold, and "most of them were bought a year ago for about 60 cents a piece," the metals trader says.
Those same gold call options trade for about $6, he added. However, in order for these bets not to expire worthless, gold has to be trading at $390 an ounce in the next few months.
And if you don't know which way the market's going to go, there's a Y2K trade for that, too.
It's known as a straddle -- a trade of an equal number of call options and put options having the same strike price and expiration date. In such a position, the buyer hopes that a drastic move pushes one option to gain more than the other loses.
"What are the possible outcomes of Y2K? The least likelihood is that nothing will happen," speculates Jordan Kahn, manager of his start-up hedge fund
Kahn Asset Management
in Santa Monica, Calif. "Flat? Come on, there's very little chance of that. There's a much better chance of a strong move in either direction."
In that case, a straddle trade using options on an index, such as the S&P 500 or
, or something less expensive, is a decent Y2K strategy. Kahn leans toward options on the
CSFB Technology Index
because his fund is mostly technology and communications. Currently, the index trades at around 278 on the
American Stock Exchange
; most traders use the
Morgan Stanley High Tech Index
Kahn says he'd buy options dated in March, in particular at-the-money puts and out-of-the-money calls. ("At the money" means the strike price is the same as the underlying stock; "out of the money" means higher than the stock price if a call, lower than the stock price if a put.)