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Zero Volatility Detonation


Sideways in, sideways out

I want to explore something that's been increasingly dominating my thoughts over the past couple of months: What would a detonation of the zero volatility crowd look like to those of us on the outside?

I want to be clear here that I don't have the answers, just a couple of suppositions.

Let's first look at the situation here. Brian Reynolds noted in several articles the Kerkorian bid for General Motors (GM) adversely affected more than a few funds. This was exacerbated by the entry of PIMCO into segments of the bond market where it usually doesn't play, dramatically torching certain players who were trying to trash the debt markets. Then GM's debt does indeed go nuclear according to the bearish game plan, but after surprisingly few shaky days we get essentially nothing. Anyone who bet that the market was going to tank really was hosed badly (last few days notwithstanding) as a snap-rally (is there any other kind lately?) grabbed the Street.

Rumors of several large funds closing their doors were followed by verified news stories of several funds closing their doors. Most of these funds overplayed the convertible bond market, but I suspect their sphere of operations were larger than that. If your rumor mill is similar to mine, stories of funds going belly-up are accelerating every day with anecdotal evidence ("Hey Dave, heard of anyone on the buy-side hiring?") providing some confirmation.

John Succo has talked about the nonsense some of these zero volatility funds engage in to try and meet their "7%, no vol" promises made to their investors. The sale of options for dirt cheap, convertible debt repackaging, etc. works as long as they continue to have money to throw at them. As I pointed out, these funds are on an incredibly short leash as their investors often insist on daily volatility updates.

I've detailed my belief that the funds who engage in "beta-matching" are choosing to be short high-beta dev-stage biotech paired against long positions in low-beta blue chips (three-letter names).

Pairing John's astute observations with my gut feelings gives us a trade where someone shorts a 3-beta biotech, goes long three 1-beta three-letter names, and sells the bejeebers out of nearly any options strike they can get their hands on for the three-letter names.

What would you get in the market as that trade was put on? A depressed NASDAQ Biotech Index (NBI), a general trend of outperformance of three-letter names over four-letter names, and low volatility measurements.

The NBI has broadly underperformed the market for a number of months and has particularly underperformed the AMEX Biotech Index (BTK) made up of larger cap, lower beta names. Measured in several different ways, short interest in the NBI has been climbing steadily for over a year. While not proof, I think there is at least support for my theory here.

Three-letter outperformance is stickier. Certainly the small cap names have been the stars over almost any recent period you care to measure. I can arbitrarily choose chart patterns to prove my case, but I don't want to. What I will rely instead on Toddo's eyes: How many times over the last year has it been "S's over N's" in his Buzz commentary? While we've been seeing more of the other recently, my recollection is we had long strings of the other. Obviously not proof here, but I'm going to call this supportive and encourage you to disagree on your own scorecard.

Low volatility readings? Check.

If we can agree for a moment the signs this trade exists are there, then what does it look like when these funds melt down?

On Thursday, the DJIA tanked and the NBI had a pretty ugly day, too.

On Friday, the DJIA tanked and the NBI was not only green but breadth was solidly positive.

If I'm right and these funds are melting down, we will see more of Friday's action in the market until their redemptions are under control. The DJIA and S&P-500 will be weak. More accurately, anything low beta will be weak. Items that are high beta like dev-stage biotech, tech, etc. will have much better relative strength if not outright market gains.

What I'm really unsure about is the options. These funds sold hundreds of millions of dollars worth of options. If they are unwinding the equity part, one would presume they are also unwinding the option part. That is so not my area of expertise so I'll rely on other people's eyes for that clue.

I am very aware I'm out on the edge of reality here. I'm putting forth conclusions based upon supposition and gut feeling more than facts.

I would never invest on this basis (nor, for those wondering, write a research opinion based upon such tenuous facts), but I often find it useful to get my wild-ass theories into the open. More often than not, something actionable comes out of it even if that action is for my Research Team to send me out for a couple of day's R&R (grin!).

Food for thought in an interesting week with the FOMC and quarter end all arriving at the same time.
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