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Derivatives

Funds Rediscover Taste For Vol Buying

Hedge funds have recovered their appetite for long equity volatility positions, as a near two-year fall in volatility seems to be stabilizing.

Hedge funds have recovered their appetite for long equity volatility positions, as a near two-year fall in volatility seems to be stabilizing. Dealers say volumes of volatility trades, particularly on single stocks, are rising and several firms, including Citigroup and UBS, are putting out research suggesting while an uptick in equity volatility may still be six months away, the market seems to have hit bottom and stabilized. The Chicago Board Options Exchange's VIX volatility index closed at 12.42% last Thursday and has sat around this level for the last two weeks.

"There's been notable buying of volatility through upside call options on single stocks," said one sales trader. But index volatility trading in Europe and the U.S. remains subdued, he added, although structured product issuance in Japan has triggered interest in buying Nikkei vol. Some funds have started buying forward-starting variance swaps again, said a trader at a European firm, who added this was a trade which last saw favor in the first quarter of the year. Traders also said hedge funds are breathing new life into dispersion trading with variance swaps, as talk of leveraged buyouts on single names has picked up, prompting realized correlation to sink. "August could be a busy month," said one flow salesman, who said he had seen volumes of vol-related trades jump in the last two weeks, in spite of the summer lull.

Strategists at several firms agree the New Year could see a turning tide for equity volatility. The retirement of Alan Greenspan, rising U.S. interest rates and high oil prices could all be triggers, said one strategist. "We are not saying go long yet, but it's now at the point where it's not worth being short any more," said Gerry Fowler, equity derivative strategist at Citi in London.

Some buysiders remain unconvinced now is the time to buy, however. "I've heard this story before," said one hedge fund manager, who attributed it to dealers' axes rather than changes in fundamentals. An analyst at a European firm agreed it could just be another false alarm, but he noted the difference this time is the increasing aggression of hedge funds looking to pick up returns after struggling in the first half of the year. "Lately, we have seen them being more aggressive, throwing money at smaller trades," he added.

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