Implied volatilities exploded to multi-year highs during the crisis in 2008, but the aftermath has caught almost everyone by surprise. Since hitting a peak of 89.53% in late 2008, the Vix, an index traded on the Chicago Board Options Exchange that reflects investor estimates of future volatility, has traded down to around 20%.

“Very few players have been able to foresee the crash in implied volatilities since the peak of the crisis,” said a senior trader at a large volatility-based hedge fund in Asia. “In particular, the shorter dated tenures have seen a huge capitulation.”

Volatility funds generally outperform in jittery markets – the flagship volatility fund of Titan Capital, founded by ex-Merrill Lynch banker Russell Abrams, rose 21.6% in May 2010 by betting on volatility trends – but not all funds have fared well.

After years of low and stable volatility, the market has changed considerably, challenging hedge funds to adapt to a different set of conditions. While volatility may be low again today, there is still a risk of sudden spikes and a protracted rise if the macroeconomic outlook worsens and a double-dip recession does play out.

At the same time, sophisticated derivative products fawned by cheap money and bull markets have lost their glitter. Since 2008, the emphasis has clearly moved away from complex structured products to plain vanilla flow. There is also an understanding that existing products and strategies need to be tailored to today’s market environment.

Convertible arbitrage is a classic volatility strategy in which funds trade the embedded equity option of a convertible bond (CB) and sometimes strip out and sell the credit part. This strategy is generally not easy to implement in Asia where the borrow of underlying stock is tight and there is a lack of credit swaps in many names. Often, funds have to take the residual delta risk or outright positions in credit instead of being perfectly hedged. In practice, the resurgence of CB issuance in Asia in 2009 and 2010 hasn’t necessarily led to many opportunities in CB arbitrage. Lower volatility lowers the risk-reward ratio of the entire trade.

Volatility-based hedge funds in Asia also have to accept that the popularity of retail structured products in the region can have a big effect on the market. A lot of retail investors went underwater in 2008 and had to deal with margin calls and forced close-outs, which kept a lid on new issuance during 2009 and 2010, but there has been a pick-up again in recent months. Lower volatility means lesser upright premium and more gearing in these products.

Dealers often get long vega exposure from these products, which tends to keep implied volatilities under pressure. Many of these products knock out on the upside, closing out these long vega positions, which means that implied volatility actually spikes with a rise in the market, sometimes leading to inverted skews for short periods. This can initially seem an attractive arbitrage opportunity to hedge funds, but the continued issuance of such products makes this phenomenon more persistent than it would seem to a newcomer.

For these reasons, many hedge funds in Asia prefer to simply trade longer-dated volatility products that are far less influenced by retail trends. The simplest such product, which has been around since 1974 when the Black-Scholes option-pricing model was first introduced, is a straddle. An investor long a straddle is long a call and a put of the same strike, and will make money if the underlying stock moves strongly in either direction.

This vanilla strategy is increasingly popular now and works well if volatility does indeed jump up on the expected names. It also prices cheaper with lower volatilities. Some hedge funds are known to develop their own volatility forecasting models and then buy longer-dated, zero-delta straddles on names their models are indicating for volatility increases. Such models encompass a large number of macro as well as sector-specific micro variables, and are developed by and army of PhDs.

Similarly, strangles are a combination of calls and puts with out-of-the-money strikes, which benefit from large movements of the stock on either side. Because of their out-of-the-money strikes, strangles are known to be a play on the wings, rather than the centre, of the volatility surface. Nassim Taleb, author of The Black Swan, has been a high-profile advocate of using such strategies in the expectation of fat tails or extreme market movements.

However, both straddles and strangles have drawbacks. To capture volatility with these strategies, hedge funds need to constantly delta hedge their positions – an added complexity that led to the rise in popularity of variance swaps, which were the first product to give funds pure exposure to volatility.

Variance swaps became popular in the 1990s for implied versus realised volatility arbitrage, term-structure plays and for use in dispersion strategies, but have seen a huge dip in trading volumes in Asia since the credit crisis. Variance swaps on single stocks are typically sold with a cap on the payout. During the credit crisis, many such caps actually got hit and, as a result, dealers have been low to start offering the product again, despite the crash in implied volatilities. Rather, dealers have replaced variance swaps with volatility swaps, which feature less toxic payouts in the event of extreme market moves. The flow for volatility swaps has increased significantly in the past couple of months.

However, equity derivatives are not always used to express a view on volatility – many hedge funds also use structured products simply as a hedge against their existing portfolio. In this strategy it is common to pay some premium to dealers to buy protection against a drop in markets – lower volatility leads to lower premiums.

Basket options on regional indices are especially popular and are treated as macro hedges for the entire long-short portfolio. The downside here is that if the indices move in opposite directions to the portfolio stocks, contrary to conventional wisdom, the protection could actually be quite deceptive. Thus, basket options are a play on volatility as well as correlation.

A zero-cost risk-reversal is also commonly used for hedging – the client sells upside to buy protection on the downside, with the strikes adjusted for a net zero premium. Flatter skew generally leads to more attractive strikes on the downside for the client. However, as funds have found out, lower volatility does not always translate into a lower skew. Even though the Vix has crashed, many US and European indices are still trading on a pretty steep skew, though Asian indices have relatively flatter term structure and skew.

While most people don’t expect volatilities to go back up to 2008 levels, it is tough to believe that it will stay so low for an extended period either, given that the economic fundamentals have not yet gone back to normal levels. Perhaps we have to get used to a slow downward drift with sudden jumps and spikes on the way.

This story was first published in the December/January issue of FinanceAsia magazine. Since then, the Vix index has continued to fall and on Friday indicated an implied volatility just under 16%.