Trading Catalysts: Who Wins? Who Loses?
"In War more than anywhere else in the world things happen differently to what we had expected, and look differently when near, to what they did at a distance."
—Carl von Clausewitz1
Federal Reserve Rate Cut Announcement
At approximately 1:14 in the afternoon of January 3, 2001, the Federal Reserve announced a 50 basis point cut in the targeted Fed funds rate.2 The announcement was intended to surprise market participants, and it did—coming almost four weeks before the next regularly scheduled meeting of the Federal Reserve Open Market Committee on January 30, 2001. The impact on the stock market was immediate. Stock prices rose sharply in reaction to the news. Many large Nasdaq-listed stocks soared. JDS Uniphase closed up 36.6%. Sun Computers closed up 29.9%. Amazon closed up 26.5%. Adobe Systems closed up 23.9%. Oracle closed up 21.3%. Even Microsoft managed to eke out a double-digit gain and closed up 10.5% for the day. Not surprisingly, the Nasdaq Composite Index reflected the broad gains enjoyed by many of its component stocks.
The performance of the cubes or QQQs—the tracking stock for the Nasdaq 100 stock index—also mirrored the rally in the underlying stocks of the index.3
Perhaps, the strength of the rally is best illustrated by the reaction of Nasdaq 100 stock index futures contract prices to the announcement.4 At one point, the price of Nasdaq stock index futures contracts—which usually leads the underlying Nasdaq 100 stock index—was up more than 20% in response to the announcement.
Nasdaq 100 stock index futures contracts are traded on the Chicago Mercantile Exchange. For many commodities, the most actively traded futures contract is the nearby or front month contract (i.e., the contract closest to expiration).5 This was certainly true for the Nasdaq 100 stock index futures contract on January 3, 2001, when the March 2001 futures contract was the most actively traded Nasdaq 100 stock index futures contract.6
Prior to the Fed announcement, Nasdaq 100 stock index futures were trading in 1 to 2 full point increments—that is, the change in notional value of the contract when futures prices changed ranged from $100 to $200. The Nasdaq 100 stock index futures contract traded at 2173 immediately before the announcement. Immediately after the announcement, the Nasdaq stock index futures price jumped by 5 full points to 2178. This was only the beginning of the move. For the next 48 seconds, the contract largely moved up (but sometimes down) in 5-point increments rising to 2240. The reaction then accelerated. For the next 75 seconds, the contract largely moved in 10-point increments rising to 2340. The reaction continued. Over the next 34 seconds, the contract had a 30-point move followed by 20- and 10-point moves.
All of this occurred within three minutes of the announcement. Then, incredibly, the reaction intensified even further, and the market started moving in 50-point increments up or down. The market continued to bounce between 2400 and 2650 largely in 50-point increments over the next minute and one half. That is, the market went from bouncing $100 to $200 between price changes before the Fed announcement to bouncing $5,000 between price changes a few minutes after the Fed announcement. The bid ask spread was not recorded. However, if one regards the bounce as a proxy for the bid offer spread, then it widened by as much as 25 to 50 times its pre-announcement amount after the Fed announcement. At this point, the Nasdaq stock index futures market was up a stunning 22% intraday (i.e., during the trading day).
To put the size of this price move in perspective, on Black Monday, October 28, 1929—the first day of the two-day 1929 stock market crash—the Dow Jones Industrial Average (DJIA) was down 13.5%. On Black Tuesday, October 29, 1929, the DJIA was down another 11.5%.7 The percentage decline in the DJIA on Monday, October 19, 1987—another stock market crash—was more than 23%. Stock market crashes are considered extreme events, yet the Nasdaq index was up in a few minutes almost the same percentage amount as these indexes fell in one or two days. Another way of looking at it is that the average annual return earned on a diversified portfolio of stocks of large U.S. companies over the 1926 to 1999 period was 13.3% and 17.6% for a portfolio of small company stocks according to Jack C. Francis and Roger Ibbotson.8 Yet, the intraday move in the Nasdaq 100 spot and futures exceeded both of these annual stock returns. Clearly, this was a large reaction in stock prices by any measure.
The initial reaction, however, apparently entailed a substantial overreaction as the futures price subsequently fell from the high of 2650. The size of the price changes narrowed to mostly $25 moves over the next two minutes as the market fell to 2425. This was followed by a period of largely 5-point moves and some 10-point moves over the next 21 minutes as the market rose back up to 2480. The Nasdaq 100 stock index futures contract closed up for the day approximately 16.7%, whereas the underlying Nasdaq 100 index closed up 18.77%.9 The more widely reported and related Nasdaq Composite Index closed up 324 points, or about 14%. In contrast, the S&P 50 stock index closed up 64 points, or 5%, whereas the Dow Jones Industrial Average closed up 299 points, or 2.8%, for the day.10 Figures 1.1, 1.2, and 1.3 depict the daily trading range (high to low) of values for the Nasdaq Composite Index, Nasdaq 100 stock index futures contract, and the Dow Jones Industrial Average for a number of days before and after the surprise cut in the targeted Fed Funds rate.11
Figure 1.1 The Fed sparks a rally on Nasdaq.
Figure 1.2 Nasdaq futures soar higher than the Nasdaq Composite.
Figure 1.3 Blue chips rally but not as much as the Nasdaq in percentage terms.