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When I wrote the article, A Market Meltdown is Possible for FSU on May 25th, I had no idea where it would lead me. One of my associates suggested that I become acquainted with an article entitled, Courting Catastrophe, (Barrons, November 24, 1997, author: Kathryn M. Welling) [See]. This article is not only paralleled by my own, but gives much more substance to my idea. The interviewee of Courting Catastrophe is Andrew Smithers, chairman of London’s Smithers & Company, which provides advice on international asset allocation to over 100 clients, mainly based in Boston, London, New York and Tokyo. After some correspondence, he agreed to answer questions as a follow-up to my own article and a potential update of the original Barrons article Q. Thank you, Mr. Smithers, for your kind replies to my questions. In your November 24, 1997 interview in Barrons, you stated that you had been working on a report as part of a program to look at various ways that a stock market crash could possibly be triggered. Have you updated your information recently regarding that report? A. Yes, we have been looking at a number of trigger points for the next downward stage to the bear market which started in March 2000.
Q. Assuming that you have kept some data on the options markets, would you say that things today are better or worse than when you first observed them? A. We have not revisited the options markets in detail. Q. I have been in touch with several hedge fund managers recently. They seem to be nervous about their positions, but are afraid of not being in the market. Many have taken out put options to protect themselves against a sudden turn. Is there anything wrong with that? A. By taking out options they will have protected their own position but increased the risk of weakness via hedging by the other side. Delta hedging of an option involves less selling than a straight sale by your hedge fund managers. If the market falls, then more selling will have to be done by those on the other side of the trade. Equally, if the market rises, delta hedging will push it up as hedgers reduce their short positions. Q. Is it possible that an “overloaded” options market was the catalyst or possibly the fuel that made the decline in 1987 so severe? A. It is generally agreed that “portfolio insurance” was the single most likely proximate cause of the 1987drop. Q. How is “portfolio insurance” not really insurance? A. Portfolio insurance is logically offensive. It was not surprising, therefore that it is agreed to have contained a logical flaw. If I understand it correctly, this lay the assumption that markets were “continuous,” i.e. that if the market price falls by one unit to a price at which point the selling order is triggered, it will be possible to deal (find a bid) at that price, or at any rate, one point lower. In practice, of course, the markets are discontinuous (e.g. offering no bid!) In this way, portfolio insurance was no insurance for those taking it out. It didn’t work, which was the equivalent of the insurer not paying. Q. How does portfolio insurance increase systemic risk? A. Systemic risk is defined as the risk of holding equities which cannot be reduced by non-diversification of the equity portfolio. It is usually measured as the standard deviation of the index returns over specific periods. If portfolio insurance is taken out, the impact is to encourage selling into a falling market and vice versa. This will obviously tend to increase short-term volatility and thus the standard deviation of returns over short periods. t may not, however, do so over longer periods. This is because stock market returns are not random but exhibit negative serial correlation. This could increase with short-term volatility. Q. In my previous article entitled, “A Market Meltdown is Possible,” I had an immense amount of difficulty quantifying the aggregate amount of risk in the options market. I could ascertain that the open interest in the June $SPX put contracts, if certain levels of decline were reached in the S&P 500 index, were far in excess of the normal money flows into the market in a given month. Does your data agree with my analysis? A. I suspect that the option market is so complex that it would be difficult to be sure that your analysis, which seems a reasonable approach, is necessarily true in practice. Option positions can be neutral, in the sense that buyers and sellers of the puts and calls are long-term investors, who are not delta hedging. I assume that the “open position” is the amount that requires such hedging, but it must be very hard to be sure. Q. Can the act of delta hedging create a potential meltdown in the Market? A. As I understand the situation, the relative impact on options value of small changes in share prices is asymmetric to the relative impact of larger changes. To preserve the hedge, therefore, selling or buying takes place in the same direction and thus tends to reinforce the change in price. It works, therefore, like portfolio insurance and could have the same impact as portfolio insurance is generally believed to have had in 1987. It may involve an additional risk, however. The costs of “failed” portfolio insurance were borne by the long-term investors. A serious problem in the options market could be bankruptcy of an intermediary, with knock-on consequences for other intermediaries and for market liquidity. Q. What are the potential implications to a seller of covered puts? Are the implications different for those selling naked puts? I am very concerned about brokers who advise their clients to sell naked puts to augment their income. What can go wrong with that practice? A. I don’t hold myself out to be an expert in the use of puts for individual portfolios. My interest had been concentrated on trying to understand the implications of the growth of the total options market relative to the equity market. In essence this implies increased volatility, which has notably not occurred in recent years. The sale of naked puts, which I take to be the situation in which the seller is not delta hedged, is obviously risky as a fall in the share price can make the put extremely valuable. The degree of risk depends not only on the risk of the share price falling, but the extent to which the strike price is “out of the money.” It is worth remembering in this case that the purchase of risky bonds has been shown, I understand, to be equivalent to buying a risk free bond and adding to the return by effectively selling a deep out of the money put – i.e. one that will only prove costly at maturity if the company goes into liquidation. Gaining income from selling naked puts and buying risky bonds are not therefore entirely different and they are just the sort of risks which many investors will be overly willing to take when income is hard to find in other ways. Q. I am becoming more convinced that the high amount of put buying in the options market poses a danger to the market’s stability. Any final comments? A. I think you must be right in principle, but the low volatility of the market in recent years suggests that there are other important factors. I wonder if the high level of buy-backs is not an important short-term stabilizer, which will weaken over time. Postscript: Since my first article, the open interest in the June put contracts (expiring this week) has expanded dramatically. If the SPX declines by only 2% to 1175, the unfunded liability of the put sellers would be approximately $79 million. In order to “delta hedge” their liabilities, the put sellers would have to sell short approximately $37.9 billion in equities. On the other hand, should the market decline 10% this week, the put sellers’ liabilities would explode to $8.77 billion. In order to “delta hedge” that liability, they might need to sell short an approximate $101 billion in equities by the end of this week (source: BigCharts.com). There simply isn’t that amount of liquidity available to meet the sudden demand if a financial accident were to happen. The final question is, “Why would so many people or institutions wish to take out “portfolio insurance” in the months of May and June?” The open interest in put contracts drops off in subsequent months. Is this simply a coincidence, or do the options buyers know something we don’t? It looks like we won’t have to wait very long. If we are able to get through this week unscathed, the potential for another such event is lessened significantly.
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