There have been some important developments in the volatility markets that I feel investors need to be mindful of – particularly now.
Historically, investors have become accustomed to seeing extreme ‘Volatility Events’ roughly every 10 years (1987, 1998, 2008). Effectively, investors would immediately become more risk-aware and it would take time for enough complacency to infiltrate the markets again as the prior collapses became further in the rear-view mirror.
Since the global financial crisis, Government regulation in the form of Dodd-Frank and Fed stress tests have severely curtailed bank balance sheets and bank’s ability to provide clients hedging in the form of selling options*. This void in the market was filled by volatility targeting firms such as, levered VIX ETPs as well as active and passive volatility selling strategies. This trend, particularly from 2015 through 2017, led to an abundance of volatility sellers and subsequently to the historically depressed levels seen in the VIX throughout 2017. Then, in February of 2018, the aptly coined ‘Volmageddon’ happened and the seemingly free-money, levered ETPs caught investors off guard. This caused products to close and many individual investors suffered dramatic losses. It appeared the decks had been cleared of most of the levered short volatility players. However, the dramatic market decline suffered in Q4 of 2018 led to additional pain in the space as passive put writing and condor strategies ran into difficulty. Finally, in March of this year we had yet another volatility event caused largely by the Corona Virus. This led to many active short-volatility managers engaged in ratio spreads and variance swaps going out of business.
3 major volatility events in the space in just over 2 years. It makes one yearn for the prior ten-year increments… My feeling is that, in large part, this decline in vol-selling pressure (in addition to Corona related fears, Socio-Economic turmoil and geo-political concerns) will lead to an extended period of an elevated VIX and that the spread between implied and realized volatility will be with us for quite some time. Another development of late is the dramatic increase in individual investors in the options market. The focus given to options trading on CNBC is but one indication of the prevalence of this trend and the following chart prepared by Morgan Stanley of the dollars chasing less than 50 contract orders is a glaring confirmation.
What we have noticed though is it appears that retail has lined up on the single stock call buying side while Institutional traders such as Hedge Funds and Banks appear to be large buyers of index puts to hedge exposures. It has also been interesting to see that from a global investing perspective, this is predominantly being done in the US and not foreign markets. This is very reminiscent of 1999, if anyone remembers dot com 1.0.
Also, worth consideration is that if we do get a Corona Virus vaccine sooner than expected and this causes implied volatility to fall dramatically, do all the short gamma strategies that are currently underweight equities need to rush in? The below chart, also from Morgan Stanley, gives us a sense of the impact this might have. A VIX below 20 will send our risk parity/vol targeting friends back to the leverage game!
Given the recent run in the markets since April and if the market rise continues, thinking back to our individual single stock call buyers, it might lead one to ask: “Who is the ‘smart money’ now……. “
Partner, Portfolio Manager
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