By Jeff Kearns
Nov. 20 (Bloomberg) -- U.S. options trading slowed this month from a record pace after hedge funds collapsed and the biggest market swings since 1929 made equity derivatives too expensive to be used as insurance against stock losses.
About 12.5 million contracts linked to shares changed hands each day in November on average, according to data compiled by Bloomberg. That’s 23 percent less than in October, the worst month for the Standard & Poor’s 500 Index since 1987, and 13 percent below the 2008 average, according to Options Clearing Corp., which processes all exchange-listed U.S. options.
Trading decreased as hedge funds suffered their worst back- to-back monthly declines in September and October, according to Hedge Fund Research Inc. Costs skyrocketed as the Chicago Board Options Exchange Volatility Index, the key measure of contract prices in the U.S., jumped to the highest level in its 18-year history in October.
“It’s broader and deeper than anything that’s happened before,” said Bill Brodsky, chief executive officer of the Chicago Board Options Exchange, the largest U.S. options market. “Our situation is as sound as we could wish it to be under these circumstances, but we’re part of the equity markets of this country and the equity markets have been knocked for a loop.”
The slowdown follows a record for annual options trading spurred by the stock-market retreat, which erased more than $30 trillion in value since October 2007. Over 3.26 billion contracts have been traded on U.S. exchanges this year, already more than the full-year record of 2.86 billion set in 2007, according to Chicago-based Options Clearing Corp.
‘Protecting’ Returns
The recent slump dims the prospects for exchanges and brokerages as investors shy away from trading equity derivatives and transfer holdings to cash to avoid more losses.
“It’s a significant drop but it doesn’t surprise me,” said Gary Katz, chief executive officer of the International Securities Exchange, the New York-based options market acquired in December by Frankfurt’s Eurex AG. “Firms are coasting to the end of the year and being very conservative in protecting what they have returned so far in 2008.”
Options are derivatives that give the right though not the obligation to buy or sell a security at a set price and date. Hedge funds are largely unregistered pools of capital that cater to wealthy individuals and institutions and allow managers to participate substantially in profits from investments. They try to make money in rising as well as falling markets.
November 1929
The S&P 500 rose or fell at least 1 percent in 86 percent of October’s trading days, making it the second-most volatile month in its 80-year history, according to S&P analyst Howard Silverblatt. Only November 1929 produced bigger swings, he said.
The CBOE Volatility Index, which averaged 17.54 last year, jumped to 89.53, its highest intraday level, on Oct. 24. It increased 91 percent in September and 52 percent in October. The measure, known as the VIX, tracks the cost of options linked to the S&P 500, which fell 17 percent last month.
The S&P 500 fell 6.7 percent to 752.44 today, sinking to the lowest closing level since April 1997. The index has fallen 49 percent in 2008, which would be the steepest annual retreat in the measure’s 80-year history. The VIX increased to 80.86, a record close.
U.S. options volume was fewer than 10 million contracts on three days in November. That’s below the total trading during the holiday-shortened session of July 3, when exchanges closed early before Independence Day.
“We’re going to see a pullback to more normal volumes,” said Ed Boyle, senior vice president for U.S. options at NYSE Euronext, the world’s largest operator of stock exchanges. “It’s a big deal because it can hurt the revenue of exchanges and the ability of trading firms to profit.”
Shifting to Cash
One reason for the decline is that investors have sold assets to protect against losses by moving money into cash, which reduces the need to use options to protect against drops in the underlying assets, said Jeremy Wien, who trades VIX options at Societe Generale SA in New York.
“People have fewer underlying positions to hedge,” Wien said. “There are fewer and fewer people taking positions because they’re saying, ‘I just want to make it to next year.’”
An estimated 700 hedge funds may go out of business by the end of the year, an increase of 24 percent from 2007, according to Hedge Fund Research. The Chicago-based firm’s Fund Weighted Composite Index fell 6 percent in September and another 6 percent in October.
“Over the last 10 years, the amount of volume that was because of hedge funds really went up as they were getting bigger and bigger and trading more and more,” said George Ruhana, chief executive officer of Chicago-based OptionsHouse LLC, the online brokerage unit of PEAK6 Investments LP. “Now their capital base isn’t going to allow them to trade as much.”
To contact the reporter on this story: Jeff Kearns in New York at jkearns3@bloomberg.net.
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