Here’s a rather scary — and under-reported — aspect of the recent sell off: Derivatives activity linked to share falls
FT Excerpt:
"The recent sharp falls in stock markets appear to have been exacerbated by an unusual wave of derivatives activity on the part of hedge funds and big banks, traders yesterday indicated.
In particular, some banks and big investors appear to have been forced into selling large amounts of equity futures because they have been acting as counter-parties to large, leveraged bets on the direction of stock market volatility in recent months – and these bets are now unravelling because volatility has increased sharply.
This forced selling has hurt equity futures index prices on markets such as the London International Futures Exchange – and depressed the value of cash equities as well, some observers suggest."
Whenever I am asked how on Earth Dow 6,800 is remotely possible, I give to answers:
a) Forced selling leads to irrational market levels;
2. Nasdaq 1,100 was similarly unthinkable;
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Source:
Derivatives activity linked to share falls
Gillian Tett
Financial Times, May 19 2006 03:00
http://news.ft.com/cms/s/7edab4a6-e6d3-11da-a36e-0000779e2340.html
I’ve been concerned about this for some time. The low volatility has encouraged increased risk in search for yield. Plus, everyone and their brother (i.e. Cody) has a hedge fund now. I think a derivative crisis will make LTCM look benign in comparison if it plays out the wrong way.
leverage is a hell of a drug
bloomberg ran an article today titled: “Default Swaps Push Derivatives to Record $298 trillion”
“The global derivatives market expanded to a record $298 trillion in the second half of 2005, led by a 34% increase in contracts to insure debt payments, the BIS said today.”
according to data that i’ve seen, that’s almost 10x the size of the global bond market.
also goes on to discuss how many trades are unsettled and were transacted on sheets of scrap paper.
the declining stock market is the tip of the iceberg….
anyone remember the stories a few of months ago about the price of greenwich office space exceeding that of manhattan? i wonder how long that will go on…
I heard Goldman London lost about USD 100mm y’day on their short vol bets. I have no idea if that’s true. I do know this: the banks are short vol out the A$$. That has been the only trade the last three years for options desks. So, you better believe there is a TON of short gamma out there that is very jumpy. The price action in stock index futures from 4 to 4:15 p.m. says a lot. You see big sellers come in on the close to square up their long deltas due to having so much short gamma. The big French banks are the worst. They wait and wait and wait until they can’t take the pain and then…. BOOM….they re-hedge. Also, the banks are not just short gamma/vega, they have short gamma to their gamma/vega positions! That’s an obnoxious way of saying that as vol goes up, they get shorter more vega and gamma.
I do not know when, but I do know that the short vega trade will unravel. When it does, it will impact both the delta and vol markets in a big, big way.
i feel slightly retarded for calling it the hiroshima omen a few days ago, but perhaps it was just a subconscious call that this drop would be worst than the hindenberg event.
in any case another hindenberg was put in from yesterday’s action.
no point in stepping in front of this train. what? for a 1-3% skim? with the possibility of real capitulation out there it doesn’t make sense. it’s hard though from going from the mentality of riskless investing to real risk management.
this decline has been orderly. even bears are putting in longs.
It has not even started … Like Erik says the bears are long. What till the bears go all short and then when the bulls start turning. Could happen soon … could happen later this year but I do think it happens this year and when it starts to go it will be like a snowball going down hill picking up steam all the way.
GLV-
i’m sure you have better things to do but can you explain that in more detail?? i’m trying to think thru this.. you have banks as counter-parties to the funds and they are short volatility. (i assume these are large otc trades done by hedge funds and dealers) and at the end of the day they rebalance their delta exposure by selling futures which makes thier gamma more short. they are short volatility, short gamma but long delta? what kind of position is long delta but short gamma?
you are obviously privy to this flow so your insight is appreciated…
GLV-
i’m sure you have better things to do but can you explain that in more detail?? i’m trying to think thru this.. you have banks as counter-parties to the funds and they are short volatility. (i assume these are large otc trades done by hedge funds and dealers) and at the end of the day they rebalance their delta exposure by selling futures which makes thier gamma more short. they are short volatility, short gamma but long delta? what kind of position is long delta but short gamma?
you are obviously privy to this flow so your insight is appreciated…
After reading this article and some follow-up on Minyanville, now it makes sense why the brokers/big derivatives shops (i.e. JPM) got whacked pretty hard while the rest of financials were only down modestly.
Let’s hope wonderboy Dimon isn’t caught with his pants down when the real storm hits
vf,
When a dealer sells a put or a call to you, he’s gotta go out and sell stock (if he sells a put) or buy stock (if he sells a call). When he does that, he’s only hedged in delta-space so long as the spot price does not move.
Now, let’s assume the dealer is short a put and sells stock. When the stock price goes down, he’s gotta sell more stock to stay hedged (the put delta goes up as stock goes down, therefore I gotta sell more delta against that put you bot). On the other hand, when the stock price goes up, he’s gotta buy stock back to stay hedged (the put delta is going down – getting closer to zero – as spot moves up, so he needs to hold less short stock against the put). Either way, when the stock moves, he’s gotta sell as the market goes lower and buy as the market goes higher to stay delta neutral (flat). That sort of position is a short gamma position. So you can be short gamma and short delta by being short options (puts or calls, it does not matter, it is all chicken) and having spot move up, and you can be short gamma and long delta by being short options and having spot move down.
Now, what’s interesting is that as vol moves up the dealers are getting shorter vega. That means their vega position has ‘gamma.’ And, as vol moves down, they are getting longer vega. It may make sense to think of a dealer being short a strip of options. And, as strike prices move lower away from spot, that dealer get short more and more options the further you go down. That sort of position would get you shorter more vol and vega as vol goes up and prices move down.
Of course, vol and spot are connected. Vol tends to go down when the market goes up and up. Vol also tends to go up as the market moves lower.
Hope that helps!
DOW 6800. LOL. I hope more folks start coming out with those kinds of projections instead of worrying about missing the “snapback” rally. I think this is just normal seasonality combined with the mid-term election cycle, for whatever reason du jour that’s causing profit taking. I believe it’s likely that this bull market has another big leg up, but that it’ll start from levels lower from where we are right now. But nowhere near DOW 6800.
i hear ya.. i think was confusing gamma with volatility. gamma is rate of change of vol.
this is the kind of stuff that is totally under the radar but is the most influential.. you typically don’t hear about it until it’s too late
Is there a weblink where I can learn about Gamma, Delta and Veta (is it Beta ?) Pls ?
NJ: google derivatives+greeks