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Hedge Funds' Loss Meant Volatility Traders' Gain

June 28, 2007

Dear Fellow Options Trader,

Just as certain as it was that Hilton Hotels (HLT) heiress Paris Hilton, already famous for being famous, would be making millions on her exit from the Los Angeles County jail, so too was it certain that the Federal Open Market Committee (FOMC) would leave interest rates unchanged at 5.25%.

As I have said here frequently, the Fed Funds futures actually trade at the Chicago Board of Trade (BOT), so anyone who follows the Fed's moves knew that the only real surprise coming from this week's two-day FOMC meeting could be the verbiage used to describe why it left rates unchanged, and whether those words and phraseology deviated significantly from the descriptive terms used to describe the last FOMC meeting.

Today's meeting seemed to serve as proof that Chairman Ben Bernanke was indeed the master of his realm, resisting some of the other members of the FOMC who were calling for rate hikes in previous meetings to reign in inflation. Such hikes would have been a disastrous mistake, and the calm and steady hand of Chairman Bernanke has indeed kept the markets on a steady course.

VOLATILITY TRADERS QUICK TO PROFIT

Another point that we've discussed here frequently is the higher level of volatility in the markets. We ratcheted our models up after the Feb. 27 spike in volatility and called for the new range to be between 12 and 18 through the third quarter.

We continue to stand by our prediction, and even the spike high of Tuesday -- when Securities and Exchange Commission Chairman Christopher Cox was testifying before Congress -- has not dissuaded us from sticking with that range.

In case you missed it, Cox said his office was investigating 12 firms for collateralized debt obligations (CDOs). That disclosure, made before Barney Frank's Financial Services Committee in the U.S. House, got traders speculating who the 12 culprits might be.

Bear Stearns (BSC) was hammered on Tuesday, as it had two hedge funds that lost billions of dollars making and trading CDOs. So, that left 10 other funds that might get hit, as all are being investigated by the SEC on how they value their assets.

The speculation pushed up volatility on the Volatility Index (VIX) very quickly, as the graphic shows. (The VIX gives a forward-looking measure of investor sentiment and is calculated using the implied volatility of several S&P 500 (SPX) index options.)

And as the feeding frenzy for protection got into high gear, the markets were getting ready to close -- which only drove the fear factor higher.



As you may know, the price of the S&P 500 cash index does not change after 4 p.m. Eastern, but the S&P 500 futures trade for another 15 minutes after the closing bell. That means the futures contracts can run to a premium over the cash index, implying that the next day will bring a bullish open, or can be sold off to a significant discount, implying a bearish open.

The latter was the case Tuesday, and the spike in volatility shows the VIX's jump to 18.90, most of which was not real, but rather the illustration of the futures trading at such a significant discount (nine points) to cash.

AN 'HONEST' DAY'S WORK

When the dust settled on Wednesday morning and the arbitrageurs (i.e., those who attempt to exploit price discrepancies among exchanges for profit) could again keep the futures in line with the cash S&P, savvy traders vaporized several percentage points off the VIX -- eventually taking it smack into the middle of the range that I've called for!

After the FOMC meeting concluded today, the VIX settled in at 15.5, and there were some happy campers out there. Why? Because you can trade the VIX, either by more sophisticated straddle and strangle strategies in the S&P 500 (which involve trading both a call and a put option in hopes that the index will move significantly in one direction but it's not yet clear which way it will go), or by simply buying call options when the VIX is trading at the low end of the range and selling when it trades up to the high end of the range.

Tuesday's panic pushed the VIX calls, and thus traders' satisfaction with the result, into the stratosphere. But the VIX leveled off a bit because of the arbitrageurs, because even though they seek to make quick money on price differences in the markets, their actions actually do manage to ensure that pricing remains accurate across the trading universe. They just happen to get rewarded (in profits) for all that extra work they do!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader