Maybe Investors Love Credit Index Options a Little Too Much

Barclays says all that activity could spark a "tail wagging dog" situation

Here is a dog wagging its tail.

Here is a dog wagging its tail.

Photographer: Gallery Stock

Options on indexes made up of credit default swaps (CDS) have been a sleeper hit over the past few years.

While trading indexes comprising CDS tied to a basket of corporate names can give investors a cheap and easy way to trade corporate credit at a time when the cash market is said to be illiquid, options written on those same indexes can do one better. The options give investors the right to buy or sell CDS indexes, such as Markit's CDX or iTraxx series. It's particularly useful since options—by definition—give investors additional leverage. That means they can amplify returns from corporate credit or offer a cheaper way of hedging for a big blow-up event in bonds than simply buying CDX protection itself.

Precise data on the volume in CDS index options is difficult to come by. The size of trades reported to the swap data depository are capped at $110 million, or €90 million, meaning we mostly have to rely on analyst estimates and anecdotal evidence to get a better sense of the market's size.

In 2005, Citigroup estimated that about $2 billion worth of credit index options were trading per month, or roughly $24 billion over the course of the year. Last December, the same Citi analysts figured that about $1.4 trillion of the instruments had exchanged hands in all of 2014, compared with $573 billion worth in 2013. If correct, that would be more than a 5,000 percent jump in activity over the course of a decade.

In research published Friday, July 17, Barclays analysts Soren Willemann and Jigar Patel take their own look at the market's size, but they do so in an interesting way by estimating the growth of trading in CDS index options vs. trading volumes in the CDS indexes themselves.

The chart below shows option volume as a percentage of the index volumes. It's been growing. Fast. Take a look, for instance, at the iTraxx Main. In the second quarter of this year, option volume accounted for 80 percent of the iTraxx volume, compared with 55 percent in the fourth quarter of 2014.

Source: Barclays

All this rapid growth has the Barclays analysts thinking: Will options written on CDS indexes start influencing the indexes themselves?

The question becomes relevant since many of these options are being written by banks that ultimately need to hedge their positions. They want to be "market neutral"—i.e., they don't want to have any direct exposure to changes in the price of the underlying CDS indexes. The risk is that the popularity of options on CDS indexes, combined with a big move in one of the indexes, could spark a flurry of hedging activity by the big dealer-banks as they struggle to get their positions back to neutral. That in turn could end up amplifying the move in the underlying index.

Here's Barclays:

The relative growth of option volumes will likely make it increasingly more common to have option hedging (by dealers) exerting a meaningful influence on index dynamics—ie, we can expect to see the “option tail wagging the index dog" ... This is particularly relevant because anecdotal evidence suggests that the majority of trades executed by investors are without delta as pure directional positions, and if anything, this proportion has been increasing over time. As such, in response to spread moves, the majority of delta-hedging will take place on the dealer side, with limited “natural” offset by investors delta-hedging in the opposite direction. Should the trend of rising relative option volumes continue, we are likely to see more cases of “pin risk” (delta-hedging of options bought by dealers making it more likely that spreads will stay around the strike) or “negative gamma” (delta-hedging of options sold by dealers, leading to amplifications of spread moves wider and tighter).

So yes. Maybe it's time to ask whether investors love credit index options a little too much.

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