TRADING WAR FOR FUN AND PROFIT

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Everyone wants to make a killing in the market, but only the sickest among us mean that literally. The furor over the Defense Departmentís proposed ìTerrorism Futures Exchangeî is proof of that. Although their exchange was a very interesting idea, it was scrapped because of the negative stigma associated with speculating on human life. While the ìTerrorism Futures Exchangeî never came to fruition, itís very public demise didnít put an end to speculating on questionable events. A number of people in the derivatives community picked up the Defense Departmentís ball and ran with it. In fact, several derivatives exchanges have staked their futures, pun intended, on these extremely controversial products. Pandoraís Box is about to be opened once again, and this time there may be no closing it.

SUPER BOWL FUTURES
The notion of speculating on the outcome of important events is nothing new. Sports gamblers do it en-masse every Super Bowl Sunday. Traders do it whenever they take a position in a stock or bond. Unfortunately, most of the products that we use to speculate on major events have only a loose correlation to the event itself. For example, many traders speculate on changes in the CPI and jobless claims numbers by taking positions in government bonds and broad stock market indexes. However, what if there was a way to cut out the middleman and trade the CPI and jobless claims numbers themselves. Now there is.

The Philadelphia Options Exchange (PHLX) was the first to announce their event futures. Anyone whoís read my Options Trader column knows that the PHLX is the whipping boy of the options business. This small exchange has been struggling for years to distinguish itself from larger options players like the CBOE and ISE. With the wolves closing in on all sides, the PHLX had only two choices ñ innovate or die. They chose the latter and invested a great deal in their electronic options trading technology. Now they are leveraging that technology to create an entirely new trading entity - the completely electronic Philadelphia Board of Trade (PBOT). ìWe are looking to replicate the success weíve had with our technology on the options side,î says Daniel R. Carrigan, Vice President of New Product Development at the PHLX. ìBottom line, we are going to change the way commodities trading advisers (CTAs) and hedge funds operate on futures exchanges.î

The second exchange to announce event futures was Hedgestreet ñ a small online futures exchange that has entered a strategic alliance with the CBOE. Hedgestreetís previous forays into the event futures market have been less than successful, but their arrangements with Clearing Corp and the CBOE gives them access to a large stable of institutional customers. Clearing Corpís customers can include event futures in their existing cross-margin accounts without having to open additional accounts. That gives Hedgestreetís products a large potential customer base right out of the gate.

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FUTURES OR OPTIONS
Although these products are called event futures, that name is very misleading. Since the term ìfuturesî conjures up notions of unlimited risk in the minds of many investors, both exchanges decided to limit the risk of their products by making them binary futures. That means that, instead of depositing funds into a margin account and then debiting or crediting that account according to market fluctuations, customers will only pay a premium for the futures at the outset of the trade. If the market moves against them, the customerís loss will be limited to the premium that he paid for the futures. The limited risk and binary payout of these instruments makes them more akin to options than to futures. It also makes them perfectly suited for a wide array of potential trading and speculating opportunities. ìThe binary, yes/no, event driven contract is an idea that applies to a wide variety of risks,î says Edward Chambliss, VP of Institutional Business Development for Hedgestreet. ìWe can create a derivatives market for things that really donít meet the typical standard for current exchange contracts. For example, we plan to offer contracts on regional residential real estate so that a prospective home buyer or seller can protect against adverse market moves. These regional futures will be the perfect hedge for someone who is selling a house in New York and buying a house in Chicago.î

PROBLEMS ON THE HORIZON
One of the primary stumbling blocks for these products is regulation. Economic indicator products such as CPI futures donít raise any regulatory red flags. However, other potential products such as corporate earnings futures, election futures, sporting event futures and M&A futures raise the specter of clashes between the CFTC, SEC, professional athletic leagues, gaming commissions, Congress and a host of other regulatory bodies. Another potential problem with these event futures/options has to do with their public perception. The PR nightmare that accompanied the announcement of the ìterrorism futures exchangeî shows how unreceptive the public can be to products that push the boundaries of good taste. If these futures become widespread, then it is only a matter of time before someone lists a product that raises the ire of the public, or even worse, the regulators.

It is easy to envision the leaders of Hedgestreet and the PHLX being dragged before the SEC or a Congressional subcommittee to explain irregular trading activities in a terrorism contract, sporting event future or other questionable product. Hedgestreetís Chambliss was quick to address these concerns. ìWe are not a casino, so we will not be writing contracts on athletic events. We will also not be writing contracts on terrorist events. We are not going to write contracts on individual equities because that is outside the purview of our regulator. In addition, we are not going to write contracts on individual lives or properties, because thatís insurance and thatís not our business.î

THE FUTURE IS BRIGHT
Although these products face numerous hurdles, it is easy to see the potential of such a product class. Their binary nature makes them perfect for both portfolio managers and traders who want to hedge the risks of specific events. It may someday be possible for traders, property owners and government bodies to hedge against natural disasters, market meltdowns, political elections and even full-scale wars. While the questionable nature of some of these products will undoubtedly spark a regulatory debate, itís exciting to see the derivatives markets expand their horizons. PHLX and Hedgestreet may have captured lightning in a bottle with these products. If these event futures take off, then it wonít be long before other major players follow suit, creating an exciting new front in the endless exchange wars.
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