ANZ Finance blog | Futures Trading and Microwave Popcorn| McGraw Hill ANZ

From Chicago to New York: Futures Trading and Microwave Popcorn

Published 12 March 2021

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Futures Trading and Microwave Popcorn -- McGraw Hill ANZ Finance Blog

It stands to reason that if you have better information than someone else or you can receive the same information sooner, you will have an advantage on the markets. There is a famous story, possibly not completely true, that everyone who reads widely in finance will eventually come across. This is the story of Nathan Mayer Rothschild who was reportedly able to make a fortune on the London markets by learning more quickly than others of Napoleon’s defeat at Waterloo.

"The value of an asset depends on the present value of its future cash flows, the faster you can compute this present value and the faster you can do the calculation under different assumptions, the faster you can make a trading decision.”

Information about events is certainly important but an event of the magnitude of Napoleon’s defeat does not happen very often. Traders try to develop an information advantage on more day to day terms. For example, if the value of an asset depends on the present value of its future cash flows, the faster you can compute this present value and the faster you can do the calculation under different assumptions, the faster you can make a trading decision. In the later 1970s and 1980s, the arrival of financial calculators quickened the pace of the markets. Some of these were able to do more complicated calculations, such as computing the Black-Scholes price for an options contract.

Of course, more computing power made its way to Wall Street as more computing power, though not of quite the same magnitude initially, made its way into households around the world. The 1987 stock market crash, which saw a quarter of the market’s value disappear in a single day, was blamed in part on computerised ‘program’ trading where computers were programmed to automatically sell more as prices fell. Some people suggested that this caused a negative feedback loop that crashed the markets.

There is some truth to this. To understand how it can happen, we must understand the relationship between the futures market and the stock market. Futures contracts are contracts for the future delivery of a good or a financial asset. You can enter a futures contracts on various things. One of these things is the value of the S&P 500 stock market index. The futures price, being a price for future delivery, reflects what traders think the actual price will be at some point in the future. Roughly speaking, if the S&P 500 futures price was, say, 3,500 for a contract that expires a month from now and the actual S&P 500 index stood at 3,600, then we interpret this as traders expecting the market to fall over the next month.

During the 1987 stock market crash, the futures price kept falling, indicating that the stock market was expected to keep falling. To hedge against this, portfolio managers (or, more to the point, their pre-programmed computers) sold more futures contracts causing the futures price to fall further, indicating more expected falls in stock market. And so, a spiral began.

“It takes about 4.5 milliseconds for information to travel between Chicago and New York by microwave transmission.”

The relationship between futures market and the stock market leads us to the latest quest for information speed. Shkilko & Sokolov (2020) explain how the futures markets in Chicago are connected to the stock market in New York. The copper lines connecting the two cities were replaced in the 1980s by fibreoptic. This quickened the speed with which information could flow from Chicago to New York. However, the fibreoptic cables take a roundabout route, reducing the speed of the information flow. Wall Street firms and technology providers realised that a faster connection could be facilitated by microwave networks, which travel in straight lines rather than around landmarks. It takes about 8 milliseconds for information to flow from Chicago to New York along the more circuitous 1980s fibreoptic cable. It takes about 6.5 milliseconds for information to flow along a newer, more direct, fibreoptic cable. And it takes about 4.5 milliseconds for information to travel between Chicago and New York by microwave transmission.

The difference in speed is small but those traders with a 2-to-3.5 millisecond head start on their competitors can use computers to lodge trades before their competitors learn of the relevant information. If you can learn more quickly than others in New York what has happened in Chicago, you can profit from differentials between the futures prices and the stock market. These opportunities have driven a quest for speed among traders and an information arms race among Wall Street firms.

On the downside, microwave networks are very unreliable when it rains. It is, it seems, a strange and unexpected fact of life, that rain anywhere between Chicago and New York can put a real dampener on trading.

Discussion Question

Is trading that relies on speed differentials really trading?

Further Reading

An introduction to the futures market is presented in Chapter 19 of the textbook.