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.

Selling by hedge funds is still putting pressure on the market (see WSJ article). As we have discussed over the last month (see posts here and here), many redemption requests by hedge fund investors are now meeting their waiting periods, causing many funds to sell assets in order to raise cash. As quoted by Gregory Horn, president of Persimmon Capital Management:

"In mid-October, redemption levels were in the 5% range but all of a sudden now it's cranking up to as high as 25% for some funds."

Certainly not good news for hedge funds, but maybe even worse news for the market. With continued forced selling, it is unlikely the market will quit trying to find a bottom. Hedge funds will continue to sell every rally, increasing volatility. As long as the VIX continues to spike and stay at elevated levels, and we continue to see the "punch-in-the-stomach" late day sell-offs after nice rallies (both of which I suspect are indications of further hedge funds selling), we will continue to be in a volatile holding pattern between 850 and 1,000 on the S&P. Unfortunately, it is difficult to know exactly when the selling will quit, as the selling and redemption requests are tied together in what is becoming a volatile catch-22 pattern that is feeding upon itself. The other day I heard an analysts say it was "too late to sell, but too soon to buy." Until hedge fund investors believe the former, it is unlikely any investors will quit believing the latter.

In an attempt to profit from the recent increases in volatility, an ex-Merrill Lynch trader is planning to start a volatility hedge fund (see Bloomberg article). The fund will try to profit by buying and selling option contracts linked to currencies, commodities, and global equities. Year-to-date, volatility funds are up 7.3 percent (see previous post), allowing them to outperforming other hedge funds. The trend in offering such funds seems to be increasing given that earlier this month CQS launched a Global Volatility Fund (see previous post), and other new funds are also raising capital. The new proposed funds are also coming at a time when the VIX has recently rose to its highest value since 2002. Could this be a contrarian signal, indicating lower volatility going forward? Possibly, but given new regulations and changing market rules, it is likely that volatility levels will be elevated for the foreseeable future.

Year-to-date, volatility hedge funds rose 7.3 percent according to data from the Newedge Volatility Trading Index (see Bloomberg article). The average equity fund fell 8.38 percent during the same time. Corporate fixed-income funds declined 4.00 percent YTD, and energy and basic- materials stock funds are down 6.36 percent over the same time frame. The 50 or so hedge funds that investing in volatility have been able to profit from the swings caused by the subprime and Fannie/Freddie news without trying to pick a direction for the market. New funds focusing on volatility are continuing to be developed nearly everyday (see previous post). This year the S&P 500 has fluctuated by more than 1 percent on 71 trading days, making this the most volatile start since 2003 and surpassing the 61 day annual average since 1928. The index is on pace to have its most volatile year since 2002, a time when there were 125 swings of more than 1 percent. The CBOE Volatility Index (VIX) also reached a five year high of 32.24 on March 17 of this year (the day after the Bear Stearns bailout), and has been 33 percent higher than in 2007, averaging 23.12 this year. Some analysts are expecting elevated volatility for the next couple of years. Nonetheless, even if volatility remains above historic levels, it is worth noting that the VIX has fallen 31 percent from its five-year high in March. As such, it appears that even trading volatility can be a volatile (and risky) move.

As reported in a recent Asian Investor article, CQS has launched the CQS Global Volatility Fund. The fund is beginning with AUM of $160 million and has a strategy that tries to profit on equity volatility valuation anomalies within market indices and on market dislocations, including the volatility of individual global equities. Not surprisingly, the fund will rely on options and futures to take positions in the volatility-driven valuation anomalies. CQS had previously launched an Asian convertible arbitrage hedge fund in 2007 that focused on convertible bond and equity strategies in Asia, also with a global volatility bias. Whether this is yet another sign that volatility has peaked, as is often the case when new funds chase the next new thing, is yet to be seen.

There is an interesting article over at the Capital Spectator blog concerning rising market volatility, and what it means for predicting the market bottom. The recent bear market in volatility ended at the end of 2006, beginning of 2007. See the chart below:

Source: The Capital Spectator blog

As mention in the post, falling volatility is a byproduct of rising prices, while rising volatility is often an indication of falling prices. While not perfect, it may be useful as another indicator in our toolbox, and another reason to assume that the bottom has not yet been made.