Dear Editor:
In your "Portfolio Insurance Revisited” roundtable (August 2000), eminent panelists pondered whether certain trading strategies, such as those known as portfolio insurance and option replication, tend to destabilize financial markets. The participants expressed a range of opinions.

The faction that considers these strategies to be malignant propounded the most colorful similes and metaphors. For example, we heard that "dynamic hedging is like a household thermostat gone berserk—the hotter the room gets, the more the heat gets turned up,” and "option pricing [is like] atomic theory...it can...lead to nuclear bombs.”

These are fighting words! While the more sober panelists disagreed, there was no forceful rebuttal. With the benefit of time for thought, I offer a simple reply to those who proffer such incendiary criticisms of an investor's voluntary strategy in a free market.

Omitting much of the detail, portfolio insurance is merely an investing strategy that enables the investor to limit her downside risk. Consider the far simpler stop-loss strategy. If the investor buys 1,000 shares of IBM at $120 per share, she can resolve to sell all shares if and when they fall in value to $100 per share.

Perhaps the critics of portfolio insurance deplore this stop-loss strategy as well. Logically, they must, since stop-loss is just a cruder version of portfolio insurance that induces greater market volatility. The investor who sells her shares when IBM falls to $100 per share does, in fact, provide positive feedback to the market. That is, the sale will push the shares down further.

From the panelists' hysterical aversion to trend-following trading, I infer that these market critics would ban or otherwise limit strategies such as stop-loss. Clearly, such interference in the market would be disastrous. Investors absolutely must have the right to sell their shares when they wish to do so and can find a voluntary buyer. These critics exhibit a regulatory control mentality that scolds investors for selling at what is considered the wrong time or for the wrong reason, and for driving the market price away from its alleged true value.

But nobody, least of all the regulator wannabes, knows what true value is in the stock market. Furthermore, these would-be regulators appear to believe that volatility and selling below the purchase price are bad, while selling above the purchase price is good. Yet the impact of a stock sale on volatility is independent of whether the stock price has moved higher or lower.

The allegation of the control-minded critics is that investment strategies such as portfolio insurance and stop-loss are detrimental to the market because they enforce the prevailing trend in stock price movements, add to market volatility, and push the market away from a true price. Their unspoken implication is that they would prohibit investors from implementing such strategies.

This cure for a dubious disease is truly frightening. It is market freedom that makes markets healthy. The irony is that the presumptive regulators cite their concern for innocent bystanders. Yet the only bystanders who truly fear the irrational selling of others are those with highly leveraged positions who, by their own design, cannot stand aside while the herd runs in the wrong direction. George Soros comes to mind as a perennial innocent bystander, as do several infamous hedge funds. But do we really need to protect the hedge funds?

Joseph Pimbley is a finance professional in New York. He can be reached at joe_pimbley@msn.com.