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Options Report: Bad Hedge Fund Bets May Have Roiled Indexes

The options market is indicating that a soured hedge fund strategy likely magnified losses in the small cap Russell 2000 index and its iShares ETF counterpart, known as the IWM .

The Russell slumped 7% last week compared with slides on the order of a little more than 4% for the Dow Jones Industrial Average and the Nasdaq Composite.

Bernie Schaeffer, the chief executive officer of Schaeffers Research says hedge funds were able to generate decent returns through a strategy of "shorting large cap growth stocks and going long in areas like small cap value." The strategy was almost turn key, generating "decent returns as long as the Russell and IWM were outperforming the S&P 500."

Things suddenly changed two weeks ago as the small cap Russell began to fall faster from the highs of the year than the S&P 500.

Schaeffer says hedge funds exposed to this strategy were left "too long in the downturn which forced them to sell stock from their portfolios and/or short the IWM or buy IWM puts. And all of this served to further blast the IWM."

Schaeffer says "most long/short equity funds are now seriously in the hole versus the S&P for the year."

Adding insult to injury, Schaeffer says these funds could suffer further losses if the market rallies "because the funds may have over hedged by buying too many puts or shorts" - though Schaeffer sees the possibility of a market rebound being "super charged" if the funds move to quickly cover their short bet losses in a rising market scenario.

Volatility to Reign Supreme

Be prepared for more volatility. That's the word from Stacey Gilbert, chief options strategist at Susquehanna Financial.

"Last week was clearly a correction where the credit market increased its risk and the equity market said, 'ok we've got to increase our risk'," says Gilbert. She adds that with the CBOE Volatility Index , a gauge of S&P 500 volatility, hovering at the 20 level, "we have 8 moves of 2-1/2% coming up between now and year end and over 50 moves of one-and-a-quarter percent."

Gilbert explains that there had been a disconnect between the "credit side and the equity side where risk increased in the credit market while the equity market for most of this year has really suggested there's less volatility - it's a disconnect to have a company that has both credit and equity saying two different things."

American Home Mortgage

Holders of August call options in American Home Mortgage have been wiped out, at least on paper, as all strikes have moved to a zero-bid, with the exception of a 5-cent bid on the August 5 calls. Conversely, holders of some of the August puts have contracts sporting gains of as much as 800% as the stock as moved from a Friday close of over $10 a share, to an open of just above $1.

The company says it can no longer provide funding for home loans and has hired advisers to explore options, including a possible "orderly liquidation of its assets."

The implosion of American Home isn't instilling much confidence in the overall financial sector. Put volume in the Financial Select Sector ETF known as the XLF remains heavy. Speculators are willing to given themselves some time and today have converged on the January puts which don't expire until the third Friday of January. Popular strikes are out of the money strikes from 31 down to 29.

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