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Derivative Markets Dwarf the Cash Markets


The market better stay in this range because if it breaks out to the downside, these managers may react with fear.

Most derivatives are in fixed income and currencies, but equity derivatives are much more significant in the sense that volatility changes are much greater. The equity markets inherently are (should be) more volatile nominally as well, so changes in prices can cause dramatic effects.

I have (ad nauseum most likely to Minyans) explained the structure of equity volatility.

In an attempt to generate returns (at the expense of risk control), just like credit spreads at nothing and emerging market exposure high, many participants are set up "short" volatility. Importantly as well, the investor base and the managers controlling decisions are not very experienced.

Over $700 billion of new funds have been created over the last two years to sell volatility (options) to generate, as they describe it, "income" for their investors. When markets are non-volatile this is a winning strategy. When markets get volatile they can lose those cumulative returns quickly.

An example is Bank of America (BAC). These funds have been selling options very cheaply for quite some time thinking this is a good company and should just trade in a range. They sold gobs of 47.5 calls and bought stock against it. When the stock rallied through 50 they bought back those 47.5 calls and sold the 50 calls. In fact, that very process probably drove the stock through that strike as they became "worried" the stock would go higher (they got greedier).

Now the stock is below 50 and they are therefore more exposed to the downside than they were. If the stock continues to drop, their greed may turn to fear: they will be essentially just long stock when they told their investors that they were generating income. They are wildly praying the stock calms down and stays around here.

It very well may. My point is that there are a lot of these positions around and they are being controlled by relatively inexperienced managers who have an investor base that really does not understand the risk.

The market better stay in this range because if it breaks out to the downside, these managers may react with fear.
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Position in BAC

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