The U.S.-led strike on Iraq bucked world equity markets last week with equity derivatives players, including hedge funds and prop traders, benefiting from war positions that have been held for several weeks. Everyone has been expecting a big war rally and from a pure directional point of view traders have been playing the upside, buying calls and selling puts, noted one trader at a New York-based dealer. Equity option volatility declined in conjunction with the equity market rise. The Chicago Board Options Exchange's volatility index (VIX), which measures the implied volatility of 30-day index options, fell to 34.46%, last Thursday, having traded at 37.32% the Monday before the attack, and as high as 40% in January, in anticipation of war. Equity option volatility typically travels in an inverse direction to equity performance, he noted.
War uncertainty had been keeping volatility high, with traders playing this with long gamma positions, said the dealer. However, some dealers were caught holding short gamma trades because the war ultimatum came a few days earlier than expected, said another trader. The dominant war trade made by hedge funds was to be short dollars, long gold, long oil, long Treasuries and short equities, the dealer noted. These trades are now being unwound as players move on to bet on the outcome of the war. The million dollar question now is how to hedge investments against any possible strike on the U.S., noted the hedge fund trader.
