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By Chris McKhann

As the investment environment continues to be especially difficult, some hedge fund managers have been driven to hang up their hats and others to jump back into some high-risk trades.

A number of big-name fund managers simply gave up in the last couple of months, most notably Stanley Druckenmiller, who along with George Soros is credited with making $1 billion in a single trade by betting against the UK pound. His fund, Duquesne, hasn't had a down year in three decades.

Several others have followed suit, and the expectation is that the list of big names to retire will grow in the next year.

On the other hand, some traders have returned to some hedge fund staples that have been largely out of fashion since getting crushed in the crisis of 2008. One is fixed-income relative-value trading. This is one of the trades that sank Long Term Capital Management and likely a number of hedge funds two years ago.

The other trade that we see coming back is the short volatility play. The average hedge fund essentially broke even in September, with many distinctly underperforming the S&P 500. And what to do if you need to play catch-up and justify your massive fees? Well, it appears that some hedge funds have decided that taking advantage of put premiums and selling volatility is the way to go.


From 2000 to 2008 hedge funds increasingly added short volatility to their portfolios to boost returns. It is a great trade until that scary black swan comes along and craps on your returns. Short puts offer one of the clear inefficiencies in the market but also opens one to potentially large losses, especially when the trade is levered up.

Late in September we saw two big put sales. In Safeway (NYSE:SWY) a trader sold 36,000 of the October 19 puts for $0.15. Not long after a trader (the same?) sold 34,000 of the Walgreen's (WAG) October 27 puts for $0.17. These were both new opening positions and did not appear to be tied to a short position in the stock that would be a hedge.

Myron Scholes, of both Black-Scholes (the options pricing formula) and LTCM fame, likened such strategies to "vacuuming up nickels" that others couldn't see. Nassim Taleb, of "Black Swan" fame, likened it to picking up nickels in front of a steamroller, as invariably such traders get run over.

This isn't to say that put selling--or option selling in general--is a bad strategy. Just look at the CBOE PutWrite Index, which has outperformed the SPX with less volatility, and that includes 1987 and 2008. But the strategy has significant risks. And it is telling that some hedge funds are jumping into the strategy after the VIX has dropped 75 percent from its highs.

It might just be the contrary indicator the bears have been waiting for. But selling volatility as it glides lower is a little like a reverse bubble, and we know that bubbles can last much longer than rationally expected.

Disclosure: No positions