uncertainty about war, terrorism or political developments can be very hazardous to your portfolio's health.
Fortunately, modern financial markets have developed innovative new products to help hedge geopolitical risk. Now you can trade futures contracts on who the next president will be, whether or not the U.S. will bomb Iran, whether Hamas will diplomatically recognize Israel, whether Osama Bin Laden will be apprehended, and many more.
But this week some investors learned that this particular financial innovation carries special risks all its own as one of these geopolitical futures markets blew up right in their faces.
The blow-up happened in the market for futures contracts on whether North Korea would test a long-range missile. That's just what Kim Jong Il's totalitarian regime did on July 4, raising tensions throughout the region and triggering a 6% drop in the Tokyo stock market. Anyone who bought the futures contracts should have had a big payday. But that's not the way it turned out. Those investors ended up losing 100% of their money.
The big payday came for those who took the wrong side of the trade. Even though North Korea did test its missiles, those who bet that it wouldn't are the ones who made all the money.
These futures contracts trade online at Tradesports, a web site based in Dublin, Ireland, that offers trading in all manner of sports, political and geopolitical events. I wrote about Tradesports in 2004, during election season.
Here's how Tradesports' futures contracts work. The North Korea missile contract was designed to expire on July 31. If, by that date, North Korea had successfully tested a missile, the contracts would expire at a price of 100 points. Each point is worth ten cents, so a contract expiring is worth $10. If there had been no test, the contracts would expire at zero in other words, worthless.
Let's say you bought the contracts on the first day they were listed, June 22. On that day you might have paid a price of around 50. That means you would have paid $5. If there was a successful test, your contracts would expire at 100, or $10, for a profit of $5. You'd have doubled your money.
For you to have bought a contract, someone needed to sell one, and his outcome would be just the opposite of yours. If you made $5, he'd lose $5.
But if there had been no test, anyone who bought the contracts at $5 would have lost all their money. That $5 would have been the seller's profit.
It all sounds so simple. Let's say you have $100,000 invested in Japanese stocks through an ETF like the iShares MSCI Japan Index fund, and you are expecting that your investment will lose 6% of its value when there's a missile test (which is exactly what happened). That means you expect to lose $6,000. So you'd hedge by buying 1,200 of the Tradesports North Korea missile futures at 50. If there's a test, you'd make $5 per contract or $6,000, just enough to offset your losses in the ETF.
The problem, though, was that North Korea did indeed successfully test a missile. And the Japanese stock market did indeed fall 6%. But instead of making $6,000 in your Tradesports futures contracts, you would have lost $6,000!
That's because, according to Tradesports, the missile launches never took place.
But on July 4, White House Press Secretary Tony Snow and National Security Advisor Steve Hadley said there had been multiple launches. On the same day, Northcom the United States Northern Command, a Defense Department unit charged with homeland security also confirmed multiple launches.
But Tradesports says no, so the winners are the losers and the losers are the winners.
Why? Because of the way Tradesports is choosing to interpret what most investors probably see as a trivial and technical element in the price wording of the futures contract. One of the contract's rules is that "the source used to confirm a test missile being launched and leaving North Korean airspace will be the U.S. Department of Defense."
The problem is that, according to Tradesports spokesman Matt Bonner, they made "numerous efforts to receive direct confirmation from the DoD" but were told "no statement involving the missile test and North Korean airspace would be forthcoming, as those specifics are considered a matter of national intelligence/security."
Bonner emphasized that "a confirmation source is, by definition and necessity, an integral part of the proposition on which contracts trade" and said that traders are "obligated to be familiar with the rules of a contract before they place an order."
But surely Tradesports could have made some effort to get its traders "familiar." On July 31, just an hour before the North Korea missile contracts were to expire worthless, I went to the Tradesports web site and bought a contract. I wanted to see if there would be any warning that the contract wouldn't pay off, even though there had been a successful launch.
There was no such warning. All I saw when I clicked the button on the screen that committed me to the trade was this description: "North Korea launch a test missile that leaves North Korean airspace on/before July 31, 2006." Not a word about the issue of sourcing confirmation an issue that, at that point, had been swirling around Tradesports for weeks.
And the Tradesports spokesman didn't say why the Northcom web site wasn't sufficient confirmation from the very source specified in the contract rules.
In my view, the contract was about whether or not there was a launch not exactly how that launch was confirmed. Especially considering that, to everyone but Tradesports, the Department of Defense did indeed confirm the launches.
Within the community of traders who participate in markets for geopolitical events, Tradesports' handling of the North Korea missile contracts has been a public relations debacle. Chris Masse, a specialist in these markets, has documented every sorry step in this disaster on his web site. Once a securities exchange has experienced a misstep this bad, it can be very difficult to build trust with investors.
It's especially unfortunate because Tradesports and its competitors are potentially offering a very valuable service to investors. And Tradesports currently has an application before the Commodities Futures Trading Commission seeking approval to operate as an "exempt board of trade" under U.S. law.
Tradesports had badly blown it here. But in the broadest sense there are some good lessons for investors. There's always risk when you trade and sometimes it comes from where you least expect it.
And there's the most risk (and the most opportunity) when you trade in innovative markets. It's like the old joke about the pioneers in the American West. It's easy to tell who they are. They're the ones with the arrows in their backs.
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him email@example.com