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Volatility shorts and this week's market correction. Like 1987?
February 7, 2018
A very insightful article in today's AFR provides some very useful insight into the market correction over the last week. Here are some sections:
Analysts say the biggest US equity reversal since 2011 was deepened by a bevy of exchange-traded products that allowed investors to wager on the Vix index, a measure of stock market volatility sometimes dubbed Wall Street's "Fear Index". However, these ETPs are just one corner of a complex and expanding "volatility ecosystem" that has evolved over the past decade and one that has raised comparisons with portfolio insurance, a hedging strategy blamed for exacerbating the market crash of 1987. Indeed, volatility is now both a major input into multibillion-dollar investment strategies and a tradeable asset in its own right.
"Monday's sell-off is an appetiser," says Christopher Cole, the head of Artemis Capital Management, a volatility-focused hedge fund. "The Vix ETP market is tiny. There is a much bigger short-volatility trade still out there."
Bruce Baker comment: This is where the BIG danger is in this.
Investors often also use volatility as a proxy for risk, embedding it into many algorithmic trading strategies. For example, if a fund has a volatility target of 10 per cent and the stock market is twice as turbulent then they automatically hold more cash to hit their target. If markets are tranquil, they use leverage to increase their exposure. In practice, they are short volatility. This approach is based on evidence that targeting volatility is a good risk management tool. But some worry that when turmoil erupts — as it did in dramatic fashion late on Monday — then volatility can beget more volatility, triggering a lethal feedback loop of selling.
the severity of the declines will inevitably trigger more automatic selling by volatility-targeting strategies. Mr Kolanovic estimates that they will have to shed about $US100bn of exposure in the coming days and weeks.
Bruce Baker comment: And this indeed is a major source of risk to markets over "coming days and weeks". This therefore suggests that investors should not be expecting markets to "normalise" quickly after the market events since last Friday. And in fact, this MAY spell "market trouble" ahead?