Trading strategy that backfired set off Dow's 70-point surge

August 26, 1994|By Floyd Norris | Floyd Norris,New York Times News Service

NEW YORK -- A strategy designed to earn the smallest of profits -- about an extra 1 percent a year -- backfired late Wednesday and played a major role in sending the Dow Jones industrial average up more than 70 points.

That surge, which was followed by a slump in stock prices yesterday, shows how the stock market can be roiled by little-known strategies using sophisticated securities.

The money manager whose strategy is being widely credited -- or blamed -- for the explosive move late Wednesday said yesterday that he was stunned by the action.

"I'm surprised it could have that kind of effect," said William T. Mullen of Loomis, Sayles & Co. "We're talking about less than $100 million of stocks," he said of the trading that appears to have been set off by his strategy.

Mr. Mullen's gamble -- essentially a bet that stock prices would not rise very rapidly -- was not the only factor in the stock market rise Wednesday, which was also influenced by a report of weak orders for durable goods such as cars and appliances and by smaller rallies in the currency and bond markets.

The reaction of other stock market players, evidently including those who had taken the opposite side of some of Mr. Mullen's bets, were an important impetus in the final leap in prices, which sent the Dow up 40 of its 70.90 points in the final two hours of trading.

Much of the impetus for buying came from the unraveling of a complex investment strategy that turned on Mr. Mullen, prompted other traders to scramble to protect themselves from losses and still others to buy in the hope of making their gain bigger and Mr. Mullen's loss larger.

To figure out Wednesday, traders and analysts had to learn about "flex options," another of the specially designed securities being invented regularly by Wall Street to allow traders, investors and speculators to do everything from minimize their losses to eke out a few extra percentage points of return.

The move appears to be the first sizable one clearly traceable to the flex option, which is named for its flexibility because it can expire on almost any day.

That means the volatility brought on by the scramble to avoid losses or solidify gains on the day the option expires can happen at any time, rather than only on the third Friday of a month, the time normal options expire.

That volatility stems from the fact that a wide variety of financial instruments -- including futures, options and swaps -- enable money managers, traders and others to shift part of the risk that comes with their investments to others, who can, in turn, shift part or all of the risk to someone else using another kind of financial instrument.

"The marketplace has gotten used to dealing with the volatility that can occur around standard option expirations dates," said Tom McManus, a strategist at Morgan Stanley. But, he added, this was something new.

Mr. Mullen does his trading in stock index options, usually trading the most popular stock index options -- those on the Standard & Poor's 500 and 100 indexes.

But in this case he traded a lesser known index, the American Stock Exchange institutional index, which is based on the performance of 75 large stocks.

That index includes such household names as Ford Motor, Caterpillar, Sears and Eastman Kodak, all of which advanced strongly Wednesday.

Index options enable a buyer to make big money if he can correctly forecast the direction of a stock market index.

Mr. Mullen's strategy is to sell options that will be worth money to the people who buy them from him only if the stock market rallies at least 5 percent over the next month or two. If that happens, he can lose money. But most often it does not, and his clients profit because the options expire worthless, while they keep the fee they earned when the options were sold.

His goal is to take in enough money from selling options to enable his clients -- mostly pension funds -- to earn about 1 percent a year above what they would otherwise earn from stock investments.

About six weeks ago, Mr. Mullen said yesterday, he sold 2,000 option contracts on the Amex institutional index, covering almost $100 million in stocks.

The options were of the new flex type and were to expire at the close of trading Wednesday. If the index closed at or below 468, the options would be worthless, and those who bought them from Mr. Mullen would be losers, having paid a fee for the options but gotten nothing. But every hundredth of an index point above 468 would require Mr. Mullen's clients to pay $2,000, a dollar for each contract.

The index, which had ended Tuesday at 466.76, spent much of Wednesday below 468. But it went above that level a bit before noon, and after dipping back to it a little after 1 p.m. it was off to the races.

At the close, the index was at 471.74, and Mr. Mullen's position, which looked in the morning as if it would end the day costing him nothing, actually cost $748,000.

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