Equity derivatives markets brace for US opening

The equity options markets were rudderless this week, with the lack of implied volatilities for the US market – used for marking and pricing options – effectively grinding options trading to a halt.

The closures created technical problems for over-the counter derivatives, with US market closures qualifying as a 'market disruption event', according to International Swaps and Derivatives Association documentation. Isda is now working to resolve discrepancies between counterparties on determining settlement prices for contracts expiring last week, although one derivatives trader said some banks would settle at Monday’s closing price for US equity options.

Although futures trading was brisk in Europe, the absence of US markets had a material impact on options liquidity, with even medium-sized deals moving the market. But the four-day closure forced most global investment banks to use highly correlated European and Asian equity markets to revalue their US trading books. While Tuesday and Wednesday saw a widespread sell-off, it was replaced by waves of optimism on Thursday. This sentiment reversed again today, indicating that traders believe the attacks on the World Trade Center and Pentagon could herald a deeper slowing of the US economy.

"Today you have seen the markets selling off aggressively, with participants panicking. A lot of derivatives dealers have been looking to buy low-delta puts and longer-dated volatility, which have been extremely low in the last few months, and declined a huge amount since the highs of ’98,” said Peter Selman, executive director in equity derivatives trading at Goldman Sachs. "Traders have been looking to buy back these short volatility positions here because they are extremely concerned that we are now in a new paradigm and because of the falling confidence of the US consumer you may get a global recession."

Using European markets as a benchmark, US equity markets are expected to fall about 10% on opening – equivalent to the second 'limit down' on S&P 500 futures, which are 10-minute trading halts intended to prevent mass selling at times of high volatility.

Recession concerns, exacerbated by the scale of inevitable US reprisals, could see some institutions sell down their positions. "Equity markets could go down much more and longer-dated volatilities would likely explode. This could be exacerbated if European retail investors begin to liquidate as they have written most of the short volatility positions in the market," said Selman.

The closest parallel to present conditions was Saddam Hussein’s invasion of Kuwait in 1990, which saw oil prices surge, US consumers switch from investments to savings and global recession pressures intensify. Should mutual funds be hit next week by large-scale redemptions, there are also concerns that a forced unwinding of positions in panicky markets could significantly dry up liquidity.

"If retail investors lose their nerve with some of their leveraged derivatives products, we could see a similar situation as Long-Term Capital Management, where volatilities pick up across the board on the back of forced unwinding," a senior trader told RiskNews.