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1 September 1987 Financial Analysts Journal Volume 43, Issue 5

How the Stock Market Can Learn to Live with Index Futures and Options

  1. Arnold Kling

The disruptive influence on the stock market of program trading tied to futures markets, particularly on days when index futures contracts expire, reflects weaknesses in the specialist trading system. On an expiration day, for example, an arbitrageur long the S&P 500 futures contract and short stocks in the index is likely to use market-at-close orders to buy the stocks, while holding the contract to expiration. If there is, in the aggregate, an imbalance of market-at-close orders (more orders to sell, say, than to buy), liquidity problems arise. The specialist must attempt to adjust prices in order to attract sufficient interest to offset demand and supply imbalances.

At this point, one might expect speculators to move in to exploit pricing anomalies. An institution, for example, could place limit orders to buy and sell stocks in the index when their prices are outside the bounds of reasonable fluctuation; such orders would tend to reduce price volatility. But the specialist’s exclusive access to the book of limit orders effectively undermines the profitability of placing such orders. The specialist’s knowledge of the degree of support for a given price gives him an information advantage other traders are unlikely to go up against.

Prohibiting specialists from trading for their own accounts on expiration days would make the supply of liquidity a fair game for other traders. The resulting increase in the supply of limit orders would reduce price swings.

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