CONCERNS OVER LOW VOLATILITY RISKS
Traders and strategists warn of shrinking potential profits
ALONG stretch of low volatility for United States stocks has made betting on continued calm a popular and lucrative trade, but traders and strategists warn that risks to the trade have mounted, while the potential for profits has shrunk.
US equity market volatility — the daily fluctuations in stock prices — has hovered near record lows for much of this year.
The CBOE Volatility Index, a gauge of the degree to which investors expect share prices to fluctuate, has averaged 11.4 this year. That is lower than for any comparable period over its nearly three-decade history.
Robust corporate earnings, encouraging economic growth and a view that world central banks are available to rescue markets if trouble strikes, have helped mute stock market gyrations and spell success for those betting on calm.
The VelocityShares Daily Inverse VIX Short-Term ETN, which makes money as long as the volatility drops or holds in place, is up about 100 percent this year.
Some traders, however, have grown more wary of increased risks to the trade.
“I think a lot of folks have gotten lulled into a false sense of security because the short trade has gone so well for so long,” said Matt Thompson co-head of Volatility Group at Typhon Capital LLC, in Chicago.
“We are still shorting volatility but we have an itchier trigger finger.”
While there are many ways to short volatility investors’ hunger for this trade is apparent in the growth in volatility-linked exchange traded products (ETPs).
Assets under management for the top two short volatility products is at US$2.8 billion (RM11.70 billion) and their exposure to volatility is at an all-time high, according to Barclays Capital.
But the very popularity of the trade has cranked up the risk.
These products hold first and second month volatility futures, buying and selling these contracts daily to keep their volatility exposure in line with the level of stock swings in the market.
Managers of these leveraged and inverse products are required to buy volatility futures as they go up and sell when they decline.
Strategists fear that this rebalancing — which needs be even more pronounced if a shock follows a period of unusually muted volatility, such as now — may be akin to adding fuel to fire.
Meanwhile, investors are not reaping as much for taking on risk as they did in the past, said Anand Omprakash, director of equity and derivative strategy at BNP Paribas, here.
What traders are being paid to take on the short volatility risk currently, is slightly below their average historical take since January 2013, and roughly six per cent lower than what they were paid monthly in mid-2016, Omprakash estimates.
To be sure, not everyone is rushing to bet on a spike in volatility, but experts do warn that investors should tread carefully when shorting volatility from here on out.