The Problem With Long Dated News Futures

Some of the most interesting contracts available are the news events futures where you can bet on a certain event happening.

Will Iran be bombed by Israel or the US before March, 2007? Will bird flu be found in the US this year? These and other news contracts are available to trade on online and have the same form as the other available contracts. The contracts can trade between 0-100 and will have a value on expiration of either 0 or $10. So if the contract is trading at 50, the price will be $5 per contract. This also implies odds of 50% of the event occurring. The idea of news futures is an attractive one and not just for the fun of speculation.

It would be theoretically possible for businesses to use them to hedge against events that would effect them. Lets say a chemical manufacturer knew that it would have to install new safety equipment if a democrat was elected president in 2008. A great way to hedge would be by using the 2008 US Presidential Election Winner contract which offers Republican, Democrat and Independent (ha!) as choices to win. To protect themselves from the additional cost of installing new equipment they could buy democrat futures. If a democrat was elected the additional costs would be offset by the gains on the contract. Taking it a step further new futures can be used to hedge against events that firms would otherwise have no protection for. A Cat 5 in NYC, a terrorist attack in LA, etc. All of these risks could be quantified and offset using an online futures market.

Unfortunately, that reality is far away from occurring. From the view of a market participant their are several difficulties that make the market as it stands unattractive for speculators and legitimate hedgers.

1. Liquidity - None of the news event contracts available so far have the depth and liquidity to be more than speculators' toys. While sporting events contracts attract many participants, news events have not received anywhere near enough traders to be serious for pros. An order of 50 contracts can move the market several points, and even if you have a good hunch or inside info there isn't enough available to make serious money.

Its a chicken and egg issue, until the contracts can attract enough traders to have a continuous, liquid market the serious traders won't touch it. But until the serious traders get involved there won't be enough depth to attract new participants. This issue, I believe, will cure itself, liquidity begets liquidity and this one just needs time.

2. Volatility - Let say you had the ultimate inside information, you knew that Iran was restarting it nuclear weapons program. Before that happened you bought as many Airstrike.Iran.Jun06 contracts as you could without moving the market. How many points would you have been able to make? Almost nothing. The market moved a total of 7 ticks from 11 to 18 (see chart), which translates to 70 cents per contract (ignoring trading fees). If you were long the entire market you would have a gain of less than $1,500 on paper and a huge problem with offsetting it.




The long dated news futures seem to move in similar ways. A gradual time decay with random spikes up on rumors. As soon as the market is satisfied there is no substance behind the rumors, the market quickly declines to its pre-spike price and resumes the time decay (see chart).



The issue is that the spikes aren't big enough to make the trading worth while and since the contracts don't move like options you can't get and extra "whip" from trading the long dated ones. So why not sell the contracts? That leads to our next issue.

3. Unattractive Margin Requirements - The way margin works on the account is that the funds that are set aside for each trade (and no longer available to make other trades until the position is closed) are based on a worst case scenario. So if I sell a 100 contracts at 30 for an event that closed in December, I have to set aside $700 for the entire year (if I hold till expy) for a chance to win $300. The funds are set aside for a long period of time, not earning income and only have limited gain. Why bother? Of course I could trade on margin but I would still need to have cash to cover swings in the account.

The combination of the above three make the market unattractive for serious speculators because it is so hard to make money. There are many opportunities in the market especially in shorter term economic numbers and news events close to expiration. For now, long dated news futures are just for fun.