Hedge funds are licking their wounds after swaption implied volatility rocketed catching most off guard. The funds had entered strangles after the U.S. interest rate cut in June wrongly predicting vol would be low during the summer. The volatility of three month options to enter five year swaps, for example, leaped from 7.7 basis points per day on June 25 to as high as 10.8 bps per day on August 1, noted one trader. Longer dated options have also seen sharp increases, with the price of one-year options to enter five-year swaps rising from 8.1bps per day to 9.75bps per day in the same period. Vol has come off a little since this peak, he added.
Hedge funds executed trades designed to take advantage of the traditional fall in vol during the summer as the market quietens down, with investors traditionally not wanting to hold options because of time-decay. In a short strangle the funds sold puts and calls with different strikes.
The situation is unlikely to ease any time soon for the hedge funds. Market professionals are divided on what direction rates are heading and this is likely to keep vol high, according to the trader. In response to the bond market woes delta trading is now dominating activity and volatility trading has quieted down, he added.