Shorting volatility: Risks mean itchier trigger fingers
Dow down 0.04 per cent, S&P up 0.06 per cent, Nasdaq up 0.07 per cent
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 — bet on lower stock gyrations — investors’ hunger for this trade is particularly apparent in the growth in volatility-linked exchange traded products (ETPs).
Assets under management for the top two short volatility products is at $2.8 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 There could be a feedback effect and maybe selling begets more selling,” said Salil Aggarwal, equity derivatives strategist at Deutsche Bank in New York.
“Risk/reward considerations would imply cutting positions to more manageable levels,” he said.
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, in New York.
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 6 per cent lower than what they were paid monthly in mid-2016, Omprakash estimates.
“You were being paid much better for much of 2016 than for much of 2017,” he said.
“I don’t know if I would necessarily say the trade has run out of steam, but I don’t think it offers the kind of risk adjusted return that it offered last year.” And the stakes are high. Strategists warn that one or two big shocks could wipe away months of profits.
The inverse volatility product XIV, while having doubled in price this year, logged an 11.4 per cent decline in August as stock gyrations picked up briefly amid escalating worries about the ability of the administration of President Donald Trump to push through its economic agenda.
“The risk/reward of the trade as a buy and hold proposition is not the same as it was before the US election or in the middle of the oil crisis in 2015 and early 2016,” said Stephen Aniston, President of Investment Adviser Black Peak Capital, in Connecticut.
Positioning in these products, primarily driven by retail players, may be more skewed to the short side than the broader market where institutional investors hold sway.
“I don’t think the risk is necessarily as big on the institutional side as it is on the retail side,” said Omprakash.
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.
US STOCKS: The S&P 500 closed slightly higher on Friday even though Apple was a drag, as worries about Washington’s latest healthcare legislation proposal eased and investors shrugged off concerns about North Korea.
Investors in the broader market were also encouraged by a jump in the Russell 2000 small-cap index, which ended with a record high close.
After a volatile day the S&P’s healthcare sector ended 0.1 per cent higher as insurance stocks regained ground after Republican Senator John McCain said he opposed his Republican peers’ latest effort to replace president Barack Obama’s healthcare law.
.“The S&P technology sector managed to eke out gain as investors had more appetite for risk even with a decline of 1 per cent in Apple shares on muted reactions to the iPhone maker’s latest product launch.