Thursday, September 13, 2007

Hedge Funds Aim to Tame Volatility

Now is the time where hedge fund managers will earn their keep. Earnings season, market volatility, high oil price and possible rate cuts. Working out a strategy that ties all these together and ends ups with a correct trade in each or a trade that makes all these factors neutral, has to be the Holy Grail over the next few weeks and months.

Strategies are being created and battle lines being drawn, it should be interesting.

Some of the trades that have been catching the markets eye have been worryingly bizarre, at least at first glance. Options trades on Bloomberg screens last week were suggesting that some investors were gambling on a 50% drop in the equity markets by September 21st. The number of options that were bet on the S&P reaching half its current level was 120,000 contracts. To put this in perspective there was only 819 at this time last year.

But far from being so-called Bin Laden trades – referring to bets that were allegedly placed on a sharp fall in US stock markets just before the September 11, 2001 terrorist attacks – a large part is down to a cheap funding strategy known as a box spread. A box spread involves combining two pairs of options with the same expiry date. For example, a trader buys S&P 500 calls with a strike price of 700, which gives it the right to buy the index at a set price and time, and sells 700 puts, which gives it the right to sell the index at a set price and time.

The third and fourth legs involve buying puts with a strike of 1,700 and selling 1,700 calls simultaneously.

This structure has a pre-determined pay-off, regardless of where the index is trading on September 21 at expiry. It is called a funding strategy, because it allows one party to lend money, typically a bank with a high credit rating, at a more attractive rate to another borrower, which does not have a balance sheet and usually pays more to borrow money, such as a market maker or hedge fund. src - Financial Online

When I was in the commodities business we always knew that volatility was our friend. If the market was going up or going down, that was fantastic, if it was going sideways it made for a boring day at the office. Trading in 1998 and 1999 in the commodities market was thoroughly mind numbing with little volatility and, consequently, less stress. My colleagues still trading in this market place since 2000 must be licking their Ferrari's clean every day and seeing their doctors regularly about their ulcers.

I was at a party with an actor friend of mine during this period and many of the people who were there openly despised anyone in our industry. One 'actress' went so far (after a gallon of cheap wine) as to suggest that people in our industry were parasites who fed off the collective wealth of the world.

My argument was that our industry (commodities trading in particular), to a certain extent takes volatility out of everyday life. I suggested that if financial mechanisms were not in place in the coffee market, for example, that you may pay £2 for a jar of coffee today and £2.50 next week. A simple and crude example I know, however, it was the best I could come up with at short notice.

She was unimpressed and continued along similar lines until I resorted to a low blow and asked what her appearance in a recent advert for Campbell's soup had done for society, she said "It pays the bills". That ended the argument and any chance I had of leaving with an actress that night.

My argument of 'price smoothing' is looking a little lame these days with rising food and energy prices to the consumer. We will see if the complicated trades being executed on trading floors throughout the world will save my theory and the rest of us, from sustained volatility that affects our everyday lives.

The actress, by the way, ended up as lawyer....Enough said.

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