This Friday, China will start trading CSI 300 index futures, allowing investors to play a derivative, either long or short, with leverage.
In a front-page editorial last week, the China Securities Journal hailed the event as a "milestone" that will create a "stabilizer" and enable the Chinese market to evolve "from prosperity to maturity".
Many people believe index futures will make the world a better place for investors. You can profit either way, the argument goes; if the market swings too far in one direction, investors will hedge, thereby reducing volatility.
The only problem is romance and reality always speak different languages. Like any other financial derivative, an index future does not change the intrinsic workings of the market, nor does it change the speculative nature of human beings.
The performance of other world markets tells us the creation of index futures often creates short-term ripples in the market, but does not have a long-term impact. For example, during the big bull market of the 1980s, the Tokyo market had a short retreat after the launch of Nikkei 225 index futures in September 1986, but ticked up again very soon. In Seoul, the market rebounded in anticipation of KOSPI 200 index futures in the spring of 1996, but soon resumed its bearish ways after futures were launched in May. The same scenarios played out from Frankfurt to London and from Mumbai to Hong Kong.
Technically, an index future is an ideal hedging tool, which is why many believe it will make the market more "balanced". In the real world, however, traders may do just the opposite, as the high leverage of index futures deters them from moving against the trend.
Take CSI 300 index futures, for example. Traders are required to put down a deposit equivalent to 15 percent of the amount they trade. If the index swings 15 percent in favor of a trader's position, the money in their account doubles. But if things go the other way, they are wiped out. This is not like playing an entertaining video game; it's like fighting in a jungle.
In the most extreme situation, an investor might see a bull market running out of steam. Theoretically, they would sell the index short, but that would take more courage than most of us possess. In this case, the market is like a train which has run out of fuel but is still running on inertia. Someone standing on the tracks, betting the train will not move another 15 yards ahead, is betting with his life.
Consider the words of Sir Isaac Newton: "I can calculate the motions of the heavenly bodies, but not the madness of people." The madness of people could push the market ahead 15 percent many times before balance reasserts itself. Index futures traders are more likely to be passengers aboard the train of madness than heroes trying to stop it.
On "Black Monday" (Oct 19, 1987), the Dow Jones Industrial Average lost almost 22 percent in a single day. By the end of the month, most of the major exchanges had dropped more than 20 percent. In July 1997, the start of the Asian financial crisis raised fears of a worldwide economic meltdown. Today, the scars of the 2007 market collapse are just starting to heal.
With or without index futures and other derivatives, the market is never static; the boom-and-bust cycle repeats itself again and again. If we believe that the nature of the market does not change, and if we believe that human nature does not change, then it is very likely that another bubble will develop in the coming decade.
There is little reason to believe the launch of CSI 300 index futures will make the market less speculative or volatile. What makes it a milestone is that it gives investors a range of options, similar to those in other markets around the world.