It’s February, and that means traders’ minds have turned to love, bonuses, the Superbowl, and the anniversary of Volmageddon.
But six years after the infamous winter blowup in the volatility market helped roil the wider S&P 500, some traders are warning that a new way of betting against ‘vol’ is setting up an eerily familiar scenario. At issue is the short-dispersion trade, in which investors use equity options to bet on the relative volatility between single stocks and stock indexes.
This is “the latest version of the ‘short volatility strategy gone too far,’” writes Michael Purves, CEO of Tallbacken Capital Advisors LLC. “This trade has worked well over the past year, but our sense is that it has simply been pushed too far.”
Typically, investors in such trades will go long volatility in a basket containing individual stocks using single-stock options, while wagering against volatility in an index like the S&P 500.
Such a trade means investors benefit if the movement of individual stocks is more than that of the overall index.
And that’s exactly what’s been happening in recent months. With the S&P 500 at or near records, its volatility as measured by the Cboe Volatility Index, known as the VIX, has fallen close to the historic low reached in late 2017 — shortly before Volmageddon. Meanwhile, dispersion in the share prices of specific companies has been particularly high with, for instance, technology giants significantly outperforming many other firms in the index.
Read More: Six Years After Volmageddon, Volatility Fears Resurface in US Stocks
The short-dispersion trade “works well when economic and macro conditions are benign and correlations among stocks falls — conditions which aptly describe today’s environment,” says Purves. But, he warns, “while today’s economic and earnings data is still quite strong, we believe that this trade has simply been pushed too far and the potential for a convex market whiplash maybe around the corner.”
For Purves, the market backdrop is similar to the months before Volmageddon, when the popularity of short-vol strategies, including two tiny volatility products, helped push up the VIX and ended up causing a selloff in the wider market. Investors who had used the products to bet against volatility had raked in money for years, but the trade (and two of the exchange-traded products which expressed it) went belly-up in February 2018.
Three-month implied correlations currently stand at a paltry 0.2, meaning “the market is pricing only a minimal amount of ‘macro’ into single stock correlations,” Purves adds. Even more worrying is the level of implied correlation relative to the VIX, he says, with the relationship between the two now close to the lowest level on record.
“This is a great signal for how far this trade has been pressed,” Purves says. In the event of an unexpected market shock, investors would have to close out these short-dispersion trades and “they will be forced to cover their short SPX volatility, which means buying back SPX index options which in turn only drives the VIX higher. Closing out the long option positions on the single stock volatility positions will only offset some of this negative profit and loss for the trade.”
Still, it’s not entirely clear what the proximate trigger for a Volmageddon repeat might be. And worries over the impact of an explosion in short-term options trading on the overall market are still being vehemently discussed by market participants — with little sign of a consensus so far.
But, in the meantime, Purves is not the only one warning about the proliferation of betting against volatility. In a recent episode of the Odd Lots podcast, Kris Sidial,
Co-CIO of the Ambrus Group, warned that the short-vol trade is back and bigger than ever, though its expression may differ across the market. “Whether it's short S&P puts, short VIX calls, short variance swaps, it has a tendency to win the majority of the time,” Sidial said. “And this expression lulls market participants into very poor habits of expressing the trade.”
Meanwhile, The Bear Traps Report run by Larry McDonald also warned back in December of multi-strategy funds putting “massive” amounts of money in the short dispersion trade. “And given where the correlation is now,” they added, “[we’re] not too sure this strategy is actually fully hedged.”