The Streak Is Over
There has been a lot of handwringing over the recent volume downturn in the options market. These concerns are understandable, if a bit overdone. After all, the growth rate has been incredibly strong in the world of options. So strong, in fact, that many people now take the repeated monthly volume records as articles of faith.

The volume downturn in August marked the end of an amazing 61-month streak of consecutive year-over-year volume increases. That is a record that few other sectors of the financial world can even begin to approach, let alone challenge. The mainstream penetration of equity and index options is truly unbelievable. For an industry that was facing a dire crisis just seven short years ago, this has been a remarkable resurgence. 

Of course, as the growth spurt passed the 30 and 40 month mark, many observers began to wonder when the other shoe would drop. After all, common sense (and past experience) tells us that no market can maintain such a phenomenal growth rate for more than a few years. It was a trend that would eventually come to a dramatic, and possibly disastrous, end.
 
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The Sky Isn't Falling
The other shoe finally dropped last month. Options volume in August totaled 263,405,886 contracts. That is certainly an impressive total, but it is far short of the record 294,211,443 contracts which changed hands in August 2007.

Has the bloom finally come off the options rose? Are we fated to see a profound retracement in options volume as institutional and retail customers abandon the options market en masse? Judging by the tremendous media coverage of the August volume decline, it would be hard for a casual options user not to feel concern over this development.

But the truth is far less grim. Granted, options volume decreased last month when compared to the August 2007 level. But that has been a foregone conclusion ever since the credit crisis exploded onto the scene last summer.

To put it simply, August 2007 was a watershed month in options history (read Stepping Into The Spotlight and Shattering Records At Mach Speed for more information). The burgeoning credit crisis, along with the corresponding plunge in the broad market and resurgence of the VIX, sent options volume soaring into the stratosphere.

The correlation between bear market conditions and options volume is hardly surprising. After all, when the market is imploding, many long-only investors and fund managers suddenly find religion when it comes to hedging. These new converts drive increases in defensive options activity such as protective puts, collars, etc. One only has to look at the options volume charts for the past few days to see more evidence of this phenomenon in action.

When the market takes a nosedive, the corresponding increase in implied volatility also leads to dramatic increases in daily options volume. After all, more options premium translates into more opportunities for options traders, market makers and customers.

The fact that the credit crisis exploded onto the scene in August only increased its impact on the options market. The summer months are the doldrums of the options calendar. By funneling so much activity into a traditionally quiet part of the year, the 2007 credit crisis set the stage for a pronounced volume downtick in 2008.

With so much volume hitting the books at the end of last summer, it didn't take a genius to realize that the phenomenal growth spurt of the options market would come to an end this summer.

to be continued in "Winners and Losers In The Options Market..."