Introduction of Futures and Options on a Stock Index and Their Impact on the Trading Volume and Volatility: Empirical Evidence from the DJIA Components

Abstract

Futures and options on the Dow Jones Industrials Average (DJIA) index have been trading on the Chicago Board of Trade since 6th October, 1997. As the most widely quoted and followed benchmark in the US stock market, the DJIA contains 30 blue chip stocks that have a total market value of more than $2 trillion and represent roughly one-fifth of the total market value of all US stocks. (These estimates are made by the Chicago Board of Trade based on the market values of the Dow 30 stocks at the time when the index futures and options were introduced.) One of the major concerns for both practitioners and academics alike is how the introduction of the index futures and options would affect the volatility of the underlying stock. The effect of stock index futures and options on the stock market has long been a subject of debate, and DJIA futures trading may help spark a new round of debate on this old issue. The different views on this issue can be no better illustrated than by the article published in the ‘Abreast of the Market’ column of the Wall Street Journal on the first trading day of the index futures and options. The front page article reported that Michael Schwartz, Chief Options Strategist at Oppenheimer & Co., believed that the volatility would increase tremendously. Patrick Catania, Executive Vice President at Chicago Board of Trade, argues otherwise, saying that volatility would not increase and the opposite was likely to be true.

Practical applications

The results of this study show that the volatility of the market has significantly increased after the start of futures and options trading on the Dow Jones Industrial Average (DJIA) index. This finding will be of great interest to market participants, especially to those investors who trade stocks that are part of the DJIA index. The higher volatility, as evidenced in the study, should mean higher required rates of return on the underlying stocks. Since investors always look for a stock with minimum risk for a given level of return, the findings of this study will help them to determine the price of the target stock. The findings of this study can also be applied for any future stock index that will be traded in the options or futures markets. The findings on the increased daily trading volume after the introduction of futures and options can also be used by investors to make their investment decisions. A higher trading volume of an asset indicates a high level of liquidity which, in turn, ensures fair pricing. Therefore, it can be a great comfort for the investors that the stock will be priced fairly whenever they want to buy or sell.

The effect of the introduction of futures and options on the Dow Jones Industrial Average index on the volatility and trading volume of its underlying stocks is examined. Traditional measures and generalised autoregressive conditional heteroscedastic (GARCH) specification show that the levels of volatility and trading volume significantly increased after the introduction of futures and options on the index. The study provides new evidence in support of the argument that futures trading attracts uninformed or irrational traders along with the rational or informed traders, which causes an increase in stock return volatility. This may indicate that, even though the market may become more liquid, the destabilising effect brought by irrational traders in both the cash and futures markets outweigh the beneficial liquidity effect.