In an address that took quite a few folks off guard at the CME Group Global Financial Leadership Conference, legendary futures trader Paul Tudor Jones called for an expansion of daily price limits across market sectors and products. Jones argued that price limits would have cut by half the decline in S&P 500 futures on Black Monday (Oct. 19, 1987), prevented the bankruptcy of many cotton merchants as a result of a March 2008 spike in cotton and prevented the May 6 “flash crash.”
His comments came as a surprise to many industry insiders in the audience who tend to support less intervention in the price discovery process. But Jones grew out of the Memphis cotton trading tradition and although he has expanded into a global macro trader, cotton traders are somewhat protective and perhaps he took the carnage in the cotton industry caused by the March 2008 spike personal. Jones said, “On that fateful day, March 4, 2008, the graves were dug and the tombstones were carved for many century old cotton merchants all across the South. A sentimental chapter of American history was about to be put to the sword in the pursuit of uncontrolled price discovery action. Though futures came in locked limit up at 88.46¢, the synthetic option on the May futures continued to trade (all the way to $1.10).”
Jones recommended that every exchange traded instrument: securities, futures, options and every form of derivative have a price limit. He includes individual stocks as well. He pointed out that although cotton futures had a four-cent limit at the time of the 2008 spike; traders were able to continue to push the price higher by creating synthetic futures through trading options.
Jones saw this as a troublesome anomaly and noted how cotton merchants were forced to exit short positions in the options markets when margins rose. I found it extremely interesting as the exact same scenario was pointed out to me by Neal Kottke (our November cover story will be up on futuresmag.com on Monday Oct. 25) just a week earlier. On Oct. 8 corn locked limit up following a bullish U.S. Department of Agriculture (USDA) report but synthetic futures created through options spreads were trading 38¢ higher. The interesting thing is that Kottke gave the example to illustrate the folly of trying to set artificial limits whereas Jones used it as evidence that a more robust price limit policy is needed. Jones acknowledged that somewhere outside of our regulatory reach someone would be willing to make a market but that they would do it at their own peril and we should set consistent limits across cash, futures and options markets.
He pointed out that the triggering of the CME’s stop logic function pausing the market briefly helped stabilize the markets during the flash crash. Prior to the temporary halt many individual equities traded as low as a penny and as high as $100,000. Jones attributed the subsequent sell-off in equities to confidence in the market being shattered.
Jones also proposed that all current limits be reviewed and possibly lowered and that cash, futures and option markets be harmonized “so that we are not forcing liquidity into one arena because another arena is shut.”
It was interesting and quite obviously from the response of those in attendance that this was not the speech many people anticipated. He does have a point in that large market moves are nearly always overdone and markets often return to a fraction of peak moves shortly after, say an unexpected unemployment number or crop report. It is also true that the peak move often wipes certain traders out before returning to a more modest adjustment. He recommends all stock index futures and options have an 8% daily limit both up and down with a 5% move initiating a one-hour timeout. “Anything greater than an 8% move in stocks in one day is probably because of something either so fantastic or so bad that taking more than another day to think about it is a good thing. Hell, most guys spend more than one day picking their fantasy football team,” Jones said.
Leaders of CME Group at the time suggested that if other exchanges followed their short timeouts the flash crash wouldn’t have happened and the market does not need a more involved price limit scheme. Currently most agricultural markets have price limits—though they are not coordinated with options—but most financial markets do not.
I caught up with Kim Taylor, managing director and president of the CME Clearing House Division later at the event to ask her about clearing margin implications. In response to a question of how an exchange would margin a contract that is locked limit but believed to be valued much higher or lower, Taylor said that the clearinghouse could require higher margin levels based on its risk assessment.
While temporary timeouts to reset stops and allow the market to catch its breath work, holding things locked limit for an entire day seems too slow to keep up with risk. In today’s 24-hour markets a shorter timeout makes sense and the big issue is always risk. The Futures model proved more robust in the recent credit crisis because of its demand for risk intermediation. Twice daily mark to market insured that mispriced risk was not allowed to build up.