Bloomberg News

Hedge Funds Shorts Match October With VIX Near 26

June 06, 2012

The selloff that erased $1.78 trillion from American equity values has pushed the cost of options to the highest levels of 2012 and prompted hedge funds to add to short sales at the fastest rate since October.

The Chicago Board Options Exchange Volatility Index surpassed 26 last week, a level not seen since December. The gain left the gauge near its price just before the Standard & Poor’s 500 Index slumped 12 percent in August and September 2011, data compiled by Bloomberg show. As the VIX has risen, an International Strategy & Investment Group measure of hedge fund bullishness has retreated by 7.4 percent.

While the cost of hedges and the amount of short selling are increasing, they may have further to go before bearishness is exhausted amid Europe’s credit crisis, according to Wayne Lin of Legg Mason Inc. The VIX (VIX) would have to gain 45 percent to reach its average price in August and September. The ISI gauge bottomed at 42 last year compared with its level of 45.3 now.

“The concerns about Europe combined with questions about the robustness of global growth are filtering into markets,” Lin, who helps oversee $639 billion as a money manager at Baltimore-based Legg Mason, said yesterday in a phone interview. “These risks make people back out of equities, cause the hedge funds to go short and push the VIX up.”

ISI’s index, based on a survey of 36 hedge funds with about $89 billion under management, plots bullish and bearish equity bets on a zero through 100 scale. Readings of zero show maximum short selling, while 100 means maximum bullish bets. At 50, hedge funds are deploying a normal ratio of long to short investments, according to ISI.

Bulls Retreat

The measure has declined at the fastest rate since October during the past nine weeks as gains in American payrolls fell short of economists’ forecasts in April and May and home sales slipped, according to ISI. It reached 42 at the end of November, the lowest level since just before the S&P 500 reached a 12-year low (SPX) in March 2009. The index peaked at 48.9 in 2012.

The VIX, as the CBOE index is known, surged 73 percent to 24.68 through yesterday since falling to an almost five-year low on March 26. The gauge measuring implied volatility for the next month based on S&P 500 options prices is trading 20 percent above its 22-year average of 20.54, data compiled by Bloomberg show. Volatility has increased before a June 17 election in Greece that may determine whether the nation exits the euro.

“The options market is pricing in fear,” Stephen Solaka, who oversees about $50 million including options as co-founder of Belmont Capital Group in Los Angeles, said in a phone interview yesterday. “You’re seeing more demand for post-June- expiration options. People are positioning to protect against some type of event.”

Whipsawed Investors

Investors who turn bearish now risk getting whipsawed if stocks rally in response to policy announcements in the U.S. and Europe, according to Steve Shafer, chief investment officer at Covenant Global Investors.

“I’d rather remain long than be hedged or place a bet towards the downside, and then have the Fed or the ECB come out with an announcement that sends risk assets up by more than 20 percent like we saw last October,” Shafer, who helps manage $315 million at the Oklahoma City-based hedge fund, said in a telephone interview yesterday. “Hedging is really expensive now in terms of the cost of the hedge, but it’s also expensive in terms of the opportunity cost.”

More Stimulus

Morgan Stanley sees increased odds of more Federal Reserve stimulus once Operation Twist, the program in which the central bank is replacing $400 billion of shorter-term debt with longer maturities, ends this month. The probability increased to 80 percent from 50 percent before the Labor Department’s June 1 report showing the slowest U.S. jobs growth in a year, according to Morgan Stanley.

The VIX fell 6.9 percent to 22.99 at 12:11 p.m. in New York today on speculation policy makers will take steps to spur economic growth. Europe’s VStoxx Index, a measure of Euro Stoxx 50 Index option prices, slipped 8.7 percent, the most since March 30, to 31.58 today.

European Central Bank President Mario Draghi said today that officials stand ready to act as the euro region’s growth outlook worsens. Fed Bank of Atlanta President Dennis Lockhart said extending Operation Twist, the central bank’s stimulus program that lengthen maturities of debt on its balance sheet, is an “option on the table.”

The Chicago Board Options Exchange S&P 500 Three-Month Volatility Index on May 18 reached 27.66, its highest level since May 2010 relative to the S&P 500’s so-called historical volatility, a measure of actual price swings during the previous 60 days, data compiled by Bloomberg show.

U.S. Downgrade

The VIX closed at 23.38 on Aug. 3, two days before S&P downgraded the U.S. government’s credit rating and catapulted the VIX to 48, the highest level since March 2009. The VIX averaged 35.75 in August and September as stocks plunged amid concern about the U.S. and European economies.

The S&P 500 fell to a one-year low on Oct. 3, extending its decline since April 29, 2011, to 19 percent. The U.S. equity gauge has fallen 9.4 percent since its almost four-year high on April 2 of this year as concern grew that global growth is slowing and the European debt crisis is worsening.

In October, the S&P 500 began a 29 percent surge through April 2. The rally started less than two weeks after the Fed announced Operation Twist.

Options traders are paying prices last seen in November to protect against S&P 500 losses. Puts 10 percent below the U.S. stocks gauge cost 11.4 points more than calls betting on a 10 percent increase, according to three-month implied volatility data compiled by Bloomberg. The price relationship known as skew on June 1 touched 11.98 points, its highest level since Nov. 17, and climbed 32 percent since its May 1 low.

No Conviction

S&P 500 June 1,200 puts, priced 6.7 percent below yesterday’s close, were the most-owned contracts, and their open interest had the biggest increase among all of the index’s options since May 17, data compiled by Bloomberg show. Three of the five most-owned S&P 500 options were bearish.

“It underscores the lack of broad conviction in the market moving higher,” Steven Blitz, chief economist for ITG Investment Research Inc., said yesterday in a phone interview, referring to the increase in volatility and short selling bets. “Given what the market has done over the previous years, the hedge funds are going to have a pretty quick trigger finger from long to short.”

To contact the reporters on this story: Nikolaj Gammeltoft in New York at ngammeltoft@bloomberg.net; Cecile Vannucci in Amsterdam at cvannucci1@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Andrew Rummer at arummer@bloomberg.net


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