GalaTime

• Bloomberg: Record Options Trading Slows After Hedge Funds Fold

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.

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.

We aren’t the only ones seeing a big dip in trading volumes.

• Barrons: Reversal of Fortunes Between Stocks and Bonds

. . . the dividend yield on the Standard & Poor’s 500 stock index touched 3.57% at 1:13 PM Eastern time, exceeding the 3.54% yield on the benchmark Treasury 10-year note, according to Bloomberg News. That’s something that hadn’t happened since 1958.

“Dividend yield, like price-to-sales, is one of those persistent metrics. We can all quibble about earnings, but dividends, particularly those of the entire S&P 500, are remarkably consistent,”.

“In a world of deleveraging, both for the financial services arena and for the economy at large, growth is less certain,” he says. “And with the economy eroding sharply, so is inflation. If stocks don’t deliver nominal growth in dividends and earnings, then their yield ‘must’ exceed the Treasury yield, in order to give us any sort of risk premium.”

• Wall Street Journal: Memories of the Depression Still Sea

There are 11.5 million Americans who are 80 and older, according to the U.S. Census Bureau. The period from the Crash of 1929 to the start of World War II shaped their lives, affected how they raised their children, and influences their reactions to today’s economic turmoil.

The memories aren’t all negative. For many, President Franklin D. Roosevelt “was like a god,” recalls Mr. Hague, and there was hopefulness amid the desperation. “People had confidence in the American way — which I am not sure they have now.”

Now, living in Vermont, she thinks only someone in Roosevelt’s mold can rescue America from its slump. “I keep thinking, why doesn’t someone do what Roosevelt did — shut down and start from scratch and give everyone jobs,” she says. “He put a lot of people — young people, older people — immediately in jobs. There were artists painting murals inside post offices and young kids out in the woods clearing away the brush.”

I can’t begin to imagine what it was like. And I do hope that we dont see this again.

What’s up with the NSE India VIX? It hit an all-time record closing high of 85 today (the intraday high was 91.78):

Is this due to the computation methodology?:

From the best bid-ask prices of Nifty 50 Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days.

The Nifty’s recently been trading at a daily ATR of 6-7%; are people extrapolating this to even more volatility in the near future?

Bloomberg: Caisse d’Epargne Had EU600 Million Derivatives Loss

Groupe Caisse d’Epargne, the French customer-owned bank in merger talks with Groupe Banque Populaire, reported a 600 million-euro ($807 million) loss on equity derivatives after stock markets plunged last week.

The loss occurred at the proprietary-trading unit of Caisse Nationale des Caisses d’Epargne, the lender’s holding company, the Paris-based bank said today. The team of about half a dozen people exceeded trading limits in terms of size and risk, said an official at Caisse d’Epargne. 

Hmm. $800M loss. Team of 6 people. That’s an average loss of $133M per person. Wonder how you feel after that.

Derivatives - The gift that keeps on taking.

Bloomberg: Korean Won Declines Most Since 1997, Stocks Drop on S&P Warning

The Korean currency slumped as much as 12 percent today, extending this year’s loss to 30 percent, Asia’s worst decline, as Standard & Poor’s said yesterday it may cut credit ratings for Kookmin Bank and six other Korean financial companies because of possible difficulties refinancing maturing debt.

South Korea’s foreign-exchange reserves dropped in each of the last six months, sliding $24.6 billion to $239.7 billion as policy makers intervened to stem the won’s slide.

• Business Standard: RBI keeps tap flowing for MFs, revives gilt auctions

With banks borrowing only Rs 3,500 crore through the repo window of Rs 20,000 crore to help mutual funds, the Reserve Bank of India (RBI) today decided to conduct special auctions every day till the limit is reached.

But with liquidity easing in the market and an expectation that the condition will improve further now that the Centre and RBI have announced a package, the government announced two bond auctions for Rs 10,000 crore. The auctions were originally scheduled for last Friday, but were cancelled due to tight market conditions.

The RBI also but the CRR by another 100 bps (now a total 250 bps cut this month): RBI announces further measures for improving domestic and foreign currency liquidity

• DNA: F&O exposure margin doubled

In a move to ringfence the markets from payment issues, the Securities and Exchange Board of India (Sebi) on Wednesday increased exposure margins for equity derivatives from 5% to 10%, with effect from October 21. That gives derivatives players six days to rejigger their outstanding positions.

V K Sharma, director and head of research at Anagram Securities says open interest currently is not too high to warrant the step. Open interest in the October contract stands at Rs 67,000 crore as opposed to Rs 81,000 crore seen just before the expiry of the September futures.

Oh this will not be fun. And we get a further drop in trading volumes after Oct 21.

Live Science: The Financial Fiasco: Emotional, Irrational, Inevitable

James Grant, editor of Grant’s Interest Rate Observer, was quoted in The New York Times as also pointing out the irrational side of financial decisions: “People keep stepping on the same rakes because money, like romance, is only partly an intellectual experience. Money, like sex, brings out some thought — but also much heavy breathing and little stored knowledge.”

On a societal or global level, why don’t more cautious-minded people balance out those who take foolish risks? In essence, Kuhnen says, people are unwilling to bet against irrationality all the time because they might “simply run of money while betting against the irrational guys.”

Bloomberg: Taleb’s `Black Swan’ Investors Post Gains as Markets Take Dive

Universa Investments LP, the Santa Monica, California-based firm where Taleb is an adviser, has about $1 billion in accounts managed to hedge clients against big moves in financial markets. Returns for the year through Oct. 10 ranged as high as 110 percent.

The Black Swan Protection Protocol bought puts and calls on a portfolio of stocks and S&P 500 Index futures, along with some European shares. The Black Swan Protocol doesn’t rely on commodities, currencies or insurance on bonds known as credit default swaps

Forbes: Dimon, Munger, Rohatyn: No More Vegas

Munger wants Wall Street balance sheets reduced by 70% and insists that the firms “be a market maker, a broker, an underwriter and a custodian of securities but not the hedge funds they have become.” He wants to restrict leverage to 50% on every securities transaction except for the Treasury trading desk where “you’re dealing with the safest securities around.”

 The abhorrent excessive compensation on Wall Street is bound to be severely reduced. If Wall Street firms can only be leveraged 10 to 1 instead of 30 to 1, then the excessive gains made on borrowed funds will be reduced by two-thirds. So the path to $5 million to $10 million annual payoffs will be more reasonable but still in the millions. Hamptons summer homes will be reduced in price. Private jets will be out of range for many. Applications to law school should go up.

Will screw up the RoI calculations for a lot of recently minted MBAs.

First, what the heck are ODIs: If ODI is not one-day international, what’s it?

ODI or ‘offshore derivative instrument’ includes PNs, but there are more. Such as, equity-linked notes, capped return note, participating return note, investment note and similar instruments issued by FIIs (foreign institutional investors) and their sub-accounts outside India against their underlying investments in listed or proposed to be listed securities (shares, debt or derivative) in India.

. . . entities which otherwise are not eligible to invest, e.g., hedge funds, use the ODI route to invest in the Indian market.

“The value of outstanding ODIs with underlying as derivatives currently stands at Rs 1,17,071 crore, which is approximately 30 per cent of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5 per cent at the end of August 2007.”

Hmm. Not chump change. And quite important in the current context - where hedge funds are liquidating everything in sight to meet redemptions and margin calls.

So, here is what the SEBI decided to do today: SEBI revises P-note norms; lifts 40% cap in ODIs

. . . the restrictions on offshore derivative instruments in will be removed. The 40 per cent cap on ODIs in both cash as well as derivative contracts will be lifted.

I would be surprised if this juices up the market in the near future; but seems good for the longer-term.

OK, there is enough blood on Dalal Street to warrant a contrarian long position.

Based on a highly scientific combination of modified P/E ratios, oversold indicators, the degree of gloom & doom on CNBC, and my inability to stay away from fire sales, I put on the following long positions today:

• Bought JUNIORBEES at 57
• Bought the Nifty Midcap-50 October future at 1650
• Bought the Nifty-50 October future at 3616

Buyer beware! Now, off to my prayers.

• Bespoke: High Yield Spreads Near Record Highs

• Bloomberg: Pantaloon Says India Malls Waiving Rents as Supply Slows Demand

Pantaloon Retail India Ltd., the nation’s biggest publicly traded retailer, said malls are waiving rents and offering to pay for interior decoration as excess supply and slowing economic growth erodes demand.

Malls in India’s top eight cities have about 20 percent of their total 40 million square feet (3.7 million square meters) of space vacant, according to real estate broker Cushman & Wakefield Inc.

• Economic Times: It’s a futures shock for many cos with F&O membership

Nearly half the stocks in the derivatives segment on NSE had a daily average turnover of less than Rs 10 crore in the cash market, at the time of their inclusion in the futures and options (F&O) list.

. . . in over two dozen stocks, the liquidity has dried up to such an extent that trading volumes have been below Rs 1-crore mark on most of the days, even for companies having a market cap of over Rs 1,000 crore. And this in the week of contracts expiry, when volumes usually shoot up as traders either square up or carry forward their positions. 

What’s interesting is that total F&O turnover hasn’t declined as much as CM turnover. So it seems that index futures & options have gotten even more popular, perhaps driven by the boom in structured products.

• Yahoo Finance: Options Clearing Corporation Statement Regarding SEC Short Sale Ban

OCC also appreciates and understands the need to curb abusive practices involving short selling, however, as written, this order does not allow for an Options Market Maker exemption to ensure liquid and orderly markets starting on Monday. This will have dire consequences on the US equities markets.

In the UK, the FSA ban on short sales does provide market maker relief. The lack of such relief in the SEC order will harm a marketplace that a great many investors have come to rely on to manage risk in their equity portfolios.

In other words: WTF were you thinking?

• Bloomberg: SEC Considers Revising Shorting Ban in Options Market

Options market makers would have been prohibited from making short sales starting next week under the ban adopted today to keep speculators from driving down stock prices. The Options Clearing Corp., which guarantees all trades exchange- listed options, said a ban would have proved “disastrous.”

Under rule announced today, market-makers such as Interactive Brokers Group Inc. and Susquehanna International Group LLP would be unable to short a stock to hedge their risks when clients buy or sell options on financial shares.

“For our retail customers, the costs of adjusting their portfolio has gone through the roof, because the bid-ask spreads have gone through the roof,”

Unintended consequences.

• Daily Options Report (Aug ‘07 post, but relevant): The Bernanke Short Options Squeeze

Which brings us to Friday. Gamma is essentially infinity in the SPX August options. They have stopped trading. They are merely cashed out at the “opening” price. The rate cut and market pop comes an hour and change ahead of the open. All a call short can do to defend his position is chase futures/ETF’s up. Some OTM calls he is short now have a 100 delta between now and the open. Sure there is an offsetting long that can sell the futures/ETF’s, but who has the urgency here? Clearly the squeezed short. And thus the kindling wood lit by the Bernanke match.

Throw in a similar dymamic on all other index/ETF options that expire at the end of the day, and Big Ben literally found the perfect minute to cause the most pain to options sellers.

Poor shorts - wrong place, wrong time.

• DNA: ‘Derivatives business is full of beautiful lies’ (Interview with Satyajit Das)

“Hedging provides certainty —- of death.

Traders lie to sales people and to risk managers. Risk managers lie to the people who think they run the place. The people who run the place lie to shareholders and regulators. Investors and corporations generally lie to themselves about their understanding of derivatives and why they are using derivatives.

The same (sub-prime lending) business model was used in private equity loans, commercial property and infrastructure and it is all going to have to be unwound.”

• Economic Times: Options outdo futures for first time in 8 years

. . . options registered a total volume of Rs 3.12 lakh crore in August, which is higher than that of futures at Rs 3.01 lakh crore. Even the average daily turnover of options (Rs 15,605.09 crore) has moved ahead of futures (Rs 15,022.44 crore) for the first time ever in August.

“Day traders are left with no options but to trade in options since trading in any other category of products attracts too much STT for a transaction to be profitable.”

I would think that the recent flood of structured products also has helped (index) option liquidity.

• NSE: FX Market Tracker

Liquidity in the newly launched rupee (USDINR) futures at the NSE is still low, but it’s too early to draw conclusions. Interesting that 12-month futures are being traded above Rs 45.