In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

36 South Investment Managers, the hedge fund managers who made 234 percent betting on "black swan" events in 2008, are now placing their bets on hyperinflation (see Bloomberg article). The new fund, called the Excelsior Fund, is targeting returns that will be five times the average inflation rate for the France, Germany, Japan, U.K., and U.S. economies. The Excelsior Fund will make its bets on inflation by buying long-dated options that are currently cheap (i.e., typically deep-out-of-the-money options). The fund will be using the options to look for increases in commodities and equity prices, along with increases in bond yields and currency volatility. Given that the options are deep-out-of-the-money, the fund will be very high risk, but carry the potential for very high returns.

Universa Investments L.P., run by Mark Spitznagel (with no ownership, but a significant investment from Black Swan author Nassim Taleb), is opening a new inflation fund, named the "Black Swan Protection Protocol - Inflation" fund (see WSJ article). While worries that inflation will be caused by increased deficit spending are nothing new (see recent blog post), the fund is making bets on what is expect will be hyperinflation - similar to, and possibly worse, than what was observed in the 1970s. Investments in the aptly named fund will include options tied to what are believed will be volatile commodities, such as corn, crude oil, and copper, in addition to associated stocks, such as the gold miners and oil drillers. The inflation fund is also making negative bets on Treasury bonds in expectation of higher yields and lower bond prices. While most investors believe that the economy will have to deal with inflation at some point, the timing is still a matter of debate. Given the use of options in the fund, which in the past tended to be deep-out-of-the-money puts when looking for a sell-off, it would seem that Spitznagel and Taleb are looking for a much quicker and, in this case, higher move to the upside for assets tied to inflation.

Option trading in the United States has decreased 23 percent compared to October (see Bloomberg article). During market moves, it would normally seem to make sense that market moves might cause increased option activity as investors look to protect their equity investments, but rapid sell-offs (and subsequent rallies) have resulted in higher volatility, driving option premiums higher. While higher option premiums may be prohibiting some traders from being able to efficiently use options for hedging, the root cause may be with the equity trading itself. Regardless of its impact on option premiums, the increased trading has reduced the number of equity trades for those who typically hedge such positions, thereby reducing the need for hedging with options. As hedge funds get smaller, their impact on trading (currently about one-third of all trading) will also decrease, reducing volume, and putting further pressure on liquidity. As traders search for a market bottom, they may be misleading themselves. We could simply be looking at a type of mean reversion to a pre-hedge-fund-explosion market with regard to asset prices and trading volumes. Current levels may be less about bottom building, and more about new market norms. Of course, this means reversion from the mean could take us into seemingly scary territory in the near future as the market recalibrates to a new post-irrational-exuberance world.

There is an interesting Bloomberg article today giving a postmortem on the Bear Stearns stock decline. In particular, the purchase of deep out-of-the-money puts are investigated. As quoted in the article, "On CSI Wall Street, the options are the DNA." As it turn out, trade data shows that 5.7 million puts traded on March 11 of this year at the $30 strike price, along with 1,649 that traded at $25, worth in total about $1.7 million. The kicker, and why this is raising eyebrows, is that when purchased these puts were over 50% below the March 11 closing price of $62.97, and also only had about a week and a half until expiration. As far as the investigators are concerned, the traders either were buying a lottery ticket, knew something was going to happen, or were in the process of making something happen. Rumors of insolvency and investor concern filled the airwaves for the rest of the week putting further pressure on the stock until it was trading around $30 by the end of trading on Friday the 14th. On that same day, with the stock opening around $54.24, the CBOE starting listing eight new put option contracts with strikes going down from $22.50 to $5, each with an expiration of only one week. That same evening Treasury Secretary Paulson called CEO Schwartz stressing the need to find a buyer to avoid the appearance of a Government bailout. And as they say, the rest is history. Even more suspect is that on Friday March 14, a total of 6,303 of the $5 strike puts traded, above the $2 initial purchase price, but well below the Friday closing price. I am sure those individuals have been receiving some calls, as well as making a few call themselves.

Nice article at the Daily Options Report about why you should not trade VIX calls as a way to trade volatility. Check out the whole article, but as a highlight:

Primarily because the guy on the other side of the trade understands them better than you do. Particularly if he is running a big derivatives portfolio with all sorts of variance risk, while you are seeing the recent VIX poundage and want to speculate that has gotten overdone. And you don't fully understand the bet you are making here. Which is absolutely nothing to be embarrassed about; it's an extremely confusing product masquarading as something not so complex.

In a sense, the VIX is an estimate of the volatility of SPX options. As such, the VIX options are therefore derivatives of a derivative, making the analysis more complicated than most of us want and need to bother with. You are better off using the VIX as an indicator of overall market volatility, and then trading options on other assets off this information.

The Daily Options Report blog recently discussed the current low levels of implied volatility as measured by the VIX. When implied volatility is low, option prices are inexpensive, relatively speaking. For long equity investors, this can create an opportunity to replace current long positions with call options, especially those positions that have recently run up. The replacement strategy allows the investor to remain exposed to the upside potential of the position, while also limiting downside risk.

Of course, the strategy is not without its potential costs. First, any gains in the sold long position will be taxed. The options also have a finite life, so the position cannot remain open as long as you may like with the equity position. There is also always the potential that the stock will remain range bound, thereby draining away the time value of your option - although your stock may have not gained much anyway over the same time frame. Once again, not a perfect strategy, but given the current low implied volatility, the strategy is worth a look. Buying puts can also give you a similar payoff, although your overall return may be different since the protective put ties up more capital as you keep your long position open.

Implied volatility has recently decreased on the S&P 500 Index options. As mentioned in Barron's: "This follows the Federal Reserve's decision to finance investment banks, seen by many investors as the equivalent of a massive put option that reduces the future possibility of extremely low stock prices." Many options investors are going cash. The low volatility reduces the premium for selling options, while the recent actions in the market (poor news and little upside, Fed propping up various industries) currently makes both long call and long put options suspect, even with lower prices.

What could cause a change? Many believe either continued poor earnings season, or a drop in consumer spending. In a recent post we discussed the lower returns generated during earning season over the last 5-6 years. Credit Suisse recommends that to hedge against poor corporate earnings, investors should take out a bear spread, buying S&P 500 SPY May 135 puts, while selling May 125 puts. Goldman Sachs gives a similar position bias, but recommends hedging with SPY puts that are 5% out of the money. As mentioned in Barron's, "Those are both good ideas, as GE's earnings shortfall may signal more bad news and rising options volatility."

Tickers: SPY