Even at Record Highs, There Are Short Term Risks for the Dow

 

You don’t need to follow the markets closely to know it’s been a good year for stocks.  One of the key indicators for equity market performance, the Dow Jones Industrial Average (DJIA), has reached an all-time high four times this year, the last one coming on May 13.  This is the continuation of a good run for the index that saw 52 records in 2013.  The S&P 500 also saw its latest in a long line of new highs on May 13.

We’re in a cycle where the words “record high” sound like more a routine than a landmark achievement for a 118 year-old index.

There are several factors that could be attributed to the current bull market – flight from emerging markets, strong earnings, or the continuation of low interest rates from the Federal Reserve.  What’s equally true is that any of these factors could reverse course at any time.

Indeed, the FOMC began discussions at their meeting in April about how they would eventually raise rates. That’s not expected any time soon, but a change to Fed stimulus might be. And uncertain political situations, like that in Russia and Ukraine, can move markets quickly and decisively.  In other words, things can change in an instant.

For anyone with exposure to the most widely referenced and traded index, that means the potential for lost returns without much warning.  It’s why we launched futures on the DJIA in 1997, and then expanded our offering to include a mini-sized ($5) and Big-sized ($25) contract. And it’s why we  introduced weekly options for the DJIA this month, a contract aimed at aligning with the immediacy of market news.

Back in 2009 we launched weeklies for S&P 500 options, and options trading for that index has taken off since then, as the chart below shows.  Last year saw a 63 percent increase in options trading for the S&P, and we saw a record of nearly 82 million contracts traded.

 

 

It’s easy to see why weekly options have become popular.  For one thing, they offer greater flexibility for managing short term risk. There was not a large knee-jerk reaction to the Fed minutes release on May 21 that resulted in huge moves in equities. But previous minutes releases and speeches by Fed Chairs have rallied the market or sent it spiraling.  So have political events and earnings news.  Weekly options allow for precision timing around these and other economic indicator events like non-farm payrolls releases.

You could look at these options the way you might look at very short term car insurance.  If you’re going to be driving down icy roads on a given day, for example, you might buy extra insurance just for that day, if it were an option.  For active participants in the equities markets, the icy roads can now be managed with increased protection.

The DJIA has lasted so long, and is referenced so often because it functions as one of the best gauges we have to the health of the overall market — 30 stocks of stable companies representing nearly every major business sector.  As former Dow Jones Indexes Executive Director John Prestbo wrote for CME Group Magazine a few years ago, “Nothing of economic consequence can happen without these stocks – these stocks’ prices – feeling it.”   Its significance is why so many small and large investors want exposure to the index. It’s also why investors need to be prepared for the inherent, and at times sudden, risks.

 

Read More:

Weekly Protection Against Moving Indices

The New Role For Commodity Indices

 

 

Thomas Boggs is senior director of equity products at CME Group.

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