Amaranth 'Highlights' Tumultuous Year

This column was originally published on Street Insight on Dec. 19 at 11:50 a.m. ET. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

As we close out this year, I wanted to review some of the highlights in derivatives this year.

1. The story with the most pervasive impact on the financial markets was that of hedge fund Amaranth.

However, while the headlines were concerned with Amaranth's failure, the real story was what the hedge fund did to the energy markets. The rise and fall of crude and natural gas prices can be linked to Amaranth. The fund participated in and perhaps exacerbated the massive speculation and volatility that took place in the energy futures and options markets. However, once the marginal speculator would no longer enter the market, the music stopped.

Energy volatility and prices collapsed, and Amaranth lost billions of dollars. Comparisons were made to Long Term Capital Management (LTCM). Once again, we saw that the collapse of a large derivative speculator, whether it was the Hunt Brothers, LTCM or Amaranth, did not create a systemic financial depression. The lesson was that the system works.

2. Implied volatilities in the equity spiked when the spring correction took place but returned to lower levels as the year progressed (see the Bloomberg chart below). The VXO stands at low levels on a historical basis. This reinforces my research which indicates that high levels of volatility are predictive of market bottoms and impending rallies but low levels of volatility are just low levels of volatility and have no predictive value. It is likely that the low levels of implied volatility are the result of hedge funds seeking to generate alpha as they constantly sell both put and call options.

Unfortunately this has been a losing formula as we have seen, with options selling on the S&P 500 and individual stocks like Google (GOOG Quote) , Sears Holdings (SHLD Quote) and Goldman Sachs(GS Quote). Nevertheless, as long as there are levered players out there who need to outperform but have no other edge, it is likely that volatility will be an easy target.

Click here for larger image.

3. Derivatives exchanges were all the rage.

Crosstown rivals the Chicago Mercantile Exchange(CME Quote) and the Board of Trade (BOT Quote) agreed to merge after both stocks climbed to new highs. Futures, commodity and options volumes have soared, making these highly valuable properties big moneymakers.

Following in the wake of that mammoth derivative exchange merger was the IPO of the New York Mercantile Exchange(NMX Quote) in one of the hottest debuts for a stock in many years. Looking to the future, I expect that after the NYSE (NYX Quote) completes its acquisition of Euronext NV it will next set its sights on a derivatives/commodities exchange as well as opportunities in the Far East. Perhaps it will try to kill two birds with one stone, if possible. My advice is to stay out of Thailand except for a vacation.

4. Options backdating was the scourge for many companies, including one of my favorites, Apple Computer(AAPL Quote), and a company that I divorced from my portfolio, United Health(UNH Quote). While I am upset that many companies have been embroiled in these scandals, what really irritates me is the inability of these companies to resolve the issues on a timely basis.

The U.S. has some of the finest finance, accounting and legal minds that the world has to offer. Why does it take so long to figure out the impact of the backdated options? This can easily be done with a spreadsheet and some junior accountants. It is a shame that a company needs more than one week to figure out the accounting impact of backdated options.

5. The credit derivative market continues to grow in magnitude and importance for a wide variety of users. These users include the natural hedgers like lenders, speculators (like hedge funds) and the vendors (such as the investments banks). Expect the bears to rally around credit derivatives as the next market to achieve "bubble" status in the next year or two.