Are Options Indicating a Mean Reversion To a Pre-Hedge-Fund-Explosion World?

By David Enke | November 20, 2008 | 1:37 PM | 0 Comments

Option trading in the United States has decreased 23 percent compared to October (see Bloomberg article). During market moves, it would normally seem to make sense that market moves might cause increased option activity as investors look to protect their equity investments, but rapid sell-offs (and subsequent rallies) have resulted in higher volatility, driving option premiums higher. While higher option premiums may be prohibiting some traders from being able to efficiently use options for hedging, the root cause may be with the equity trading itself. Regardless of its impact on option premiums, the increased trading has reduced the number of equity trades for those who typically hedge such positions, thereby reducing the need for hedging with options. As hedge funds get smaller, their impact on trading (currently about one-third of all trading) will also decrease, reducing volume, and putting further pressure on liquidity. As traders search for a market bottom, they may be misleading themselves. We could simply be looking at a type of mean reversion to a pre-hedge-fund-explosion market with regard to asset prices and trading volumes. Current levels may be less about bottom building, and more about new market norms. Of course, this means reversion from the mean could take us into seemingly scary territory in the near future as the market recalibrates to a new post-irrational-exuberance world.