Long-dated implied volatility on the Nikkei 225 dropped last week, prompting talk of selling from hedge funds closing out long Nikkei vol positions. By Friday, two-year implied vol had started to recover but it had dropped to about 18% at the start of the week compared to near 20% the week before.
"People are getting hammered," said one flow salesman, who explained a popular strategy over the last six months has been to buy long-dated Nikkei volatility and sell Euro STOXX 50 or Standard & Poor's 500. The trigger for the dropoff was a mystery, as implied volatily is usually inversely related to the underlying equity and the Nikkei was still falling early last week, after news of a regulatory investigation into internet firm Livedoor (DW, 1/20). The volatility term-structure inverted, with front-dates still high in response to the extended index selloff.
One suggested explanation was that Nikkei issuance of auto-callables, which involve dealers implicitly selling call options to investors, had peaked in a New Year rush to sell investment products. The volume option selling connected to these structures may have been strong enough to push down implied volatility. One trader noted it is easy to forget the market is still thin at longer-dates and sensitive to big ticket deals. The other suggestion was that a hedge fund long a sizeable Nikkei outperformance option had exited the position, prompting other funds to consider following suit. Funds which held tight were rewarded when implied volatility started to tick up again on Friday.
