MORGAN STANLEY: Here's how the controversial volatility trade that just imploded can make a full recovery
- The short-volatility trade that imploded earlier in February had all of Wall Street talking about how it worsened the stock market correction.
- Still, Morgan Stanley says short-volatility investors should be able to rebuild their positions, but they should be patient.
Don't call it a comeback.
Less than a month after the controversial short-volatility trade imploded, wiping out a pair of popular exchange-traded products (ETPs), Wall Street is already plotting its return to glory.
Morgan Stanley in particular has some ideas about how shorting of the Cboe Volatility Index (VIX) - also known as the stock market fear gauge - can make a recovery. And right now, the firm says investors simply need time to let conditions normalize.
It estimates that in four to six months, realized volatility will be around its normal historical level of 12%, an area that would allow traders to withstand the type of shock that rocked markets in early February. Morgan Stanley is specifically referring to situations when one-month realized volatility climbs into the 90th percentile.
The short-volatility recovery could occur even faster - perhaps in just two or three months - if realized volatilities decline from current levels and wind up near the 25th percentile, according to the firm.
But these conditions don't exist in a vaccum. Morgan Stanley highlights a handful of fundamental factors that could help ease market worries and allow conditions to settle back down for short-volatility traders.
"A strong global growth backdrop, policy hikes fully priced in for several markets, and the valuation pullback give the market some room to consolidate," Phanikiran Naraparaju, a senior cross-asset strategist at Morgan Stanley, wrote in a client note. "Our view is that the February sell-off was a healthy bull market correction after the excesses of January."
With all of this in mind, it's important to remember why the short-volatility trade is so significant. First and foremost, it's one of the best-performing strategies of the past decade, according to Morgan Stanley. In 2017, the trade performed much better than any major equity index, surging almost 200%.
Secondly, it was blamed for exacerbating the recent 10% stock market correction. As the VIX doubled, short-volatility investors were forced to buy it in order to close their positions. What resulted was the implosion of the two aforementioned ETPs, which lost a combined 95% of their value.
Long story short, it's been an immensely profitable trade - but also a source of immense risk, as evidenced by the recent blow-up.
And even though Morgan Stanley is recommending short-volatility enthusiasts stay patient as the dust settles, some traders are already jumping back in with gusto. In the two weeks following the VIX ETP reckoning, investors poured more than $575 million into the ProShares Short VIX Short-Term Futures ETF (SVXY).
In the end, it's important to note Morgan Stanley is not necessarily advising against shorting volatility right now. After all, there's still money to be made on a day-to-day basis.
The firm is just saying if another blow-up transpires before volatility conditions normalize, the bold investors re-entering could be in for some serious pain.
