AP/Peter Morgan
- The net position of investment products that track the CBOE Volatility Index - or VIX - has slipped into short territory for just the second time in history.
- Goldman Sachs is worried about what might happen to the market if a spike in volatility ever causes this trade to unwind.
- The situation is arguably more dire than the last time traders were net short, because the stock market has gone that much longer without a major reckoning.
Despite repeated warnings of a painful reckoning, traders can't seem to wean themselves off one of the market's riskiest investment strategies.
The trade in question is the shorting of stock market volatility using exchange-traded products (ETPs), and the situation has reached an extreme only seen once before in history. The net position of ETPs that track the CBOE Volatility Index - or VIX - has become short for just the second time in their eight-year history, according to data compiled by the equity derivatives team at Goldman Sachs.
One possible interpretation of this is that investors are assuming too much risk. But Goldman is more worried about how exposed these positions will be if the VIX spikes unexpectedly - something that could cause traders to quickly reverse positions.
Regardless of how you look at it, this is a tenuous situation for markets. And it's one that's arguably more dire than the last time the ETPs were net short, simply because stocks have gone that much longer without the type of earth-shattering market event that could cause such an unwind.
The chart below shows the dynamic in action, with the line representing the vega outstanding on VIX futures, which is defined as an option's sensitivity to changes in price swings on the underlying asset. Simply summarized, the VIX ETP market currently has more net exposure to short volatility strategies than to long ones, and that's rare.
Goldman Sachs Global Investment Research
This rarity has accompanied a shift in how volatility is traded. Goldman notes that while VIX ETPs have historically served as hedging tools, they're being increasingly used to make directional short bets. It's a trend that's also caught the eyes of experts across Wall Street.
Perhaps the most outspoken critic of the trade has been Marko Kolanovic, the global head of quantitative and derivatives strategy at JPMorgan - a man so influential that his research reports have moved the market in the past. He said in late July that strategies suppressing price swings reminded him of the conditions leading up to the 1987 stock market crash, and he has since doubled down on the warning on multiple occasions.
More recently, Societe Generale's head of global asset allocation, Alain Bokobza, compared the continued VIX shorting by hedge funds to "dancing on the rim of a volcano." He warned that a "sudden eruption" of volatility could leave traders "badly burned." The comments echoed those made by Bokobza a couple of weeks prior, when he maligned the "dangerous volatility regimes" in the global marketplace.
Even one of the foremost pioneers of modern volatility has gotten in on the criticism - in an interview with Business Insider, the Hebrew University of Jerusalem professor emeritus Dan Galai described the capital being used to short the VIX as "stupid hot money," and he likened the trade to "a substitute for going to Vegas and betting on the roulette."
Worried yet? Fear not, because Goldman has a recommendation that could save you some pain further down the road. The firm says to apply short-dated VIX-based hedges to your portfolio, just in case the dreaded volatility spike does transpire. And in order to do so, a trader should buy February VIX calls - defined as bets the gauge will rise - while selling April VIX calls.
"With the price of VIX tail hedges so unusually high for a low-volatility environment, we prefer paired positions to outright options," Goldman equity derivatives strategist Rocky Fishman wrote in a client note. "Particularly as a volatility spike would likely be short-lived as long as economic and equity fundamentals remain strong."
