One of the market's hottest trades could see 'catastrophic losses'
And it's worked.
But while many have started viewing the current environment as the new normal, JPMorgan's quant guru has a warning: it's not going to last - and when the shift comes, it's going to hurt.
One big reason why shorting volatility can be dangerous is the ever-present possibility that the market will make a unexpectedly sharp move, according to Marko Kolanovic, the firm's global head of macro quantitative and derivatives strategy.
The best recent example of this came on May 17, when the S&P 500 slipped 1.8%, only to make back most of the loss over following week. Still, the damage to volatility bears was done, with the VIX - also known as the S&P 500 fear gauge - spiking as much as 46% to 15.56.
"May 17 and similar events bring substantial risk for short volatility strategies," Kolanovic wrote in a client note. "Given the low starting point of the VIX, these strategies are at risk of catastrophic losses."
He sees this happening if the VIX, which is currently sitting near 10, spikes up to 20, near the average level for the gauge. While that would be an unprecedented move, Kolanovic says "this time may be different." Even a move up to around 15 could stir up trouble for volatility bears if it results in a liquidity collapse, he said.
For context, the VIX closed at 10.48 on Tuesday and has been mostly stuck near a record low since the start of May.
So why is volatility so low in the first place? Kolanovic argues it's due to a series of unsustainable factors, including low correlations. With stocks moving more independently of one another, it's more difficult for them to gather momentum in a particular direction, keeping price swings subdued.
Volatility is also muted because of large inflows into passive funds that are generally price-insensitive, according to Kolanovic. Not only do these investors "almost never sell," but they also refrain from making large directional bets, nor do they overreact to market events, he said.
"Regardless of those, we think current low levels of volatility is not a new normal and will not last very long given the amount of leverage, rising rates, and the approaching reduction of central bank balance sheets," Kolanovic wrote.
