before a group of New York-based members of the Chicago Mercantile
New York, New York,
parody, written in the aftermath of the 1987 stock market crash,
was inspired by one of our many trips to the East Coast to
meet with executives of the major securities firms of the New
York Stock Exchange.
sitting on the airplane on the way back to Chicago, I was struck
by the obstinate, pious, and blind refusal by otherwise highly
intelligent and successful members of the U.S. financial world
to accept that index arbitrage was simply a market mechanism
and not an inherently evil strategy whose only purpose was
to lower stock prices.
I first began working as a runner for Merrill Lynch on the old
floor of the Chicago Mercantile Exchange, I was about as green
as you can get. I knew nothing about futures, and was equally
ignorant about all aspects of the marketplace. But that did not
disqualify me for my new job. As a runner I wasn't required to
know anything. Besides, I would learn. My school, so to speak,
would be all around me—what I would see and hear.
process worked. My teachers were my contemporaries, those clerks
and runners on the floor of the Exchange who had been there at
least a day longer than me. I idolized every one of them and
hung on their every word.
dean of our little band was a clerk named Peter who was much
older and had been there longer than any of us. In fact, I recall
wondering why he was still a runner, but dismissed the thought
on the basis that I really didn't understand how the system worked.
Besides, it didn't matter since, to my good fortune, Peter became
my friend. He was a very serious fellow who spoke with a keen
sense of authority and knew everything. In short, Peter's word
day Peter swore me to secrecy and divulged why he was still a
runner. "It is the best place to learn," he said in a whisper
and explained that as soon as he learned everything he would
become a trader and make a million dollars.
it was clear that I was trustworthy, Peter imparted to me still
another secret, a discovery that, in his words, "was bound to
make me a ton of money."
call it," he confided with a measure of pride, "the pink law
of market dynamics."
exclaimed, duly impressed, "what does it mean?"
means," he whispered, looking about to see if anyone was listening, "it
means that colors control the direction of the market."
direction of the market? You're putting me on."
I'm not," he said emphatically, "colors control."
mean a color can make a market go up or down?"
right," he nodded solemnly, "it's a discovery I've made about
market dynamics. I know for a fact the color pink makes the market
was an embarrassing moment of silence while I pondered the revelation
and then shamefully admitted I was a dunce and didn't quite get
smiled and with a fatherly pat on my back told me not to worry. "In
time you will understand."
fact, years later I did understand.
seems that Peter was working for a major brokerage firm that
had hired a new floor manager. The new manager was innovative
and adopted a unique procedure to help brokers quickly execute
the firm's business. The new policy required that all "buy" orders
be written on blue order forms and all "sell" orders be written
on pink order forms.
Peter's mind, the procedure took on a deeper meaning. After all,
no sooner would he deliver a pink order to a broker, then the
market would tend to go lower. (Sell orders do have this curious
effect on a market.) Over time, to Peter, the color became the
controlling element. Pink was no longer the messenger, the vehicle.
Instead pink assumed the substantive role. Pink became the reason
for the market's decline.
have passed. Believe it or not, Peter's unique sense of logic
did not hamper his success in the world of markets. Today, Peter
is chief clerk for a fund manager managing billions of dollars.
By accident, I ran into him the other day and, after reminiscing
about the good old days, I jokingly asked him if he remembered
his old pink law of market dynamics.
knowing look crept into his eyes. "Damn good law," he said lowering
his voice, "except that its applicability is much broader than
I realized at the time. It goes far beyond the color pink."
what?" I asked, ready to go along with the gag.
index arbitrage," Peter responded with conviction.
let me guess. You mean index arbitrage makes the market go down
just like the color pink does?"
hesitated. "Peter, you can't be serious?"
bet I am."
Peter, that's stuff and nonsense. Arbitrage is simply a transference
between two or more markets. Net, net it does not add any new
pressure to the process. It is a reactive procedure with a sum
what you like," Peter responded with anger.
tried again, "I hate to break this to you, but arbitrage is no
more the cause of a market decline than is the color pink. It
is a practice as old as the market itself. In fact, index arbitrage
is beneficial to the marketplace by adding liquidity and balancing
out price differentials."
was about to say more, but one look at Peter's face told me that
this was not a subject to pursue. Things could get violent.
see, Peter never forgot the lessons he learned as young man in
the business. In the recesses of Peter's mind, his pink law of
market dynamics lives on. He has simply replaced the color with
index arbitrage. The principle is the same, its simplicity undeniable.
After all, no sooner is there index arbitrage (as a consequence
of "sell-programs"), then the stock market goes lower. (Actually
the reverse is equally true as a consequence of "buy-programs," but
Peter's logic doesn't bother with rising prices since they are
always welcome and need no specific cause factor.)
Peter's mind, index arbitrage has become the controlling element.
To him, index arbitrage is no longer the messenger, the vehicle.
Instead, it has assumed the substantive role. Index arbitrage,
like the color pink, became the reason for the market's decline.
you are still having difficulty comprehending Peter's logic or
his pink law of market dynamics, allow me to make a modest suggestion.
You will need to study the finer points of the marketplace. I
suggest you begin with the story of "Chicken Little." Read it
carefully and in no time you too will understand why the sky
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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