Second generation derivatives have been around for a while but today derivative trading vehicles feed off each other to the point that you can trade the S&P 500 in a half dozen different iterations. There is the index, option, futures, options on futures, the spider ETF, options on the ETF and futures on the ETF. They are growing in number and complexity, as investors search for different ways to manage risk. We find that derivatives of derivatives are proliferating.
Much in the news these days is default swap index products, which are baskets of 125 default swaps, each of which is a derivative on an underlying corporate bond. The default swap index helps investors avoid the cost of having to construct positions in individual corporat bonds. However there are some potential pitfalls. By making it so much easier to take on or layoff risk, it is quicker, easier and cheaper to get into trouble due to the large amount of leverage associated with most derivative products.
"Sometimes you get an explosion of volatility in the market that is unanticipated in that fourth iteration of a derivative; and as a result, viola! You've got a fiasco," says a professor of finance at the Stanford Graduate School of Business.
Futures, Fall 2005
CME Economic Derivatives
CME has partnered with Goldman Sachs to provide auctions for key economic indicators and to extend the auction framework to other financial products currently under development. CME Economic Derivatives offer a broad range of options as well as forwards on the outcome of economic data including U.S. nonfarm payrolls, the Institute of Supply Management PMI, weekly initial jobless claims, advance retail sales, European inflation, the International Trade Balance and GDP. This will enable market participants to hedge or take an exposure directly tied to the release of economic indicators.
Chicago Mercantile Exchange release, September 28, 2005
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Derivatives of Derivatives of Derivatives
By: Pete Kendall, September 30, 2005 |
Given the technical situation, what might we conclude about the psychological aspects of wave V? The 1920's bull market was a fifth wave of a third Supercycle wave, while Cycle wave V is the fifth wave of a fifth Supercycle wave. Thus, as the last hurrah, it should be characterized, at its end by an almost unbelievable institutional mania for stocks and a public mania for stock index futures, stock options, and options on futures.
The Elliott Wave Theorist, April 1983
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It may not seem like a very dramatic forecast now because it happened, but calling for a mania back in Apirl 1983 was an extreme long-shot. But to be honest, the incredible extreme to which the speculative fervors has taken the complexity and leverage of financial derivatives is surprising even to us. The ability to place wagers or "hedge" expectations with instruments tied to various economic indicators just about takes the markets over the line that traditional separates them from a casino. As today's issue of The Elliott Wave Financial Forecast points out, however, an explosion in credit swaps, which are designed to "spread the risk" of corporate default , is the perfect place for the great derivatives boom to end up. |
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Additional References
The Elliott Wave Theorist, August 1983
Falling Into Place
Can we say that the environment on Wall Street is conducive to developing a full-blown speculative mania? In 1978, an Elliott analyst had no way of knowing just what the mechanisms for a wild speculation would be. 'Where's the 10% margin which made the 1920's possible?' was a common rebuttal. Well, to be honest, we didn't know. But now look! The entire structure is being built as if it were planned.
Options on hundreds of stocks (and now stock indexes) allow the speculator to deal in thousands of shares of stock for a fraction of their values. Futures contracts on stock indexes, which promise to deliver nothing, have been created for the most part as speculative vehicles with huge leverage. Options on futures carry the possibilities one step further. And it's not stopping there.
Remember, this is just the set-up phase. When the stock market makes the news reports every single day (as gold did starting about two months before the top, remember?), when your neighbors find out you're 'in the Business' and start telling you about their latest speculations, when stories of stock market riches hit the pages of the general newspapers, when the best seller list includes 'How to Make Millions in Stocks,' when Walden's and Dalton start stocking ELLIOTT WAVE PRINCIPLE, when almost no one is willing to discuss financial calamity or nuclear war, when mini-skirts return and men dress with flash and flair, and when your friends stay home from work to monitor Quotron machines (since it's more lucrative than working), then you know we'll be close. At the peak of the fifth wave, the spectacle could rival Tulipomania and the South Sea Bubble.
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