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HOME >The Hidden Risks of Low Volatility

Volatility…. a market like no other, with sellers and no buyers. The most interesting market of all. The most educational market of all.


Yes, the realized volatility saw historical lows in July in many asset classes. This is secondary. What is interesting? That the implied volatility touched historical lows in the same time. Normally, it goes the other way. When markets realize low volatility the implied trades way higher anticipating the reversion to the mean. The compression of the implied-realized spread took a further historical step ahead in July: it became negative in some markets (for example 3-month 5Y UST -0.27%, 1 month EUR -0.52%, etc.). So, all is so perfect across all asset classes that we are heading from a historically low volatility regime to an even more historically low volatility regime? Not really. It’s just selling, selling and more selling – much of it trapped in a spiral which, as we will explain later, is beyond toxic for the respective strategies. Some marketed, ironically, as “defensive”.

As one of our managers pertinently points out, while one might be tempted only to be amazed by equities, the current percentile of implied volatility across asset classes is truly interesting:

1st percentile in the 2y tenor of USD 30yr
2nd percentile in 5y tenor USD 30yr
1st percentile in gold (2 months tenor)
4th percentile in investment grade (1 month tenor)
And, not last:
0 percentile in S&P 500 6 month tenor (we’ve never had a better world)
0 percentile in Nikkei 225 6 month tenor

The short interest in volatility linked exchange traded products has increased exponentially (see for example in April VXX ETN), as did the direct selling in VIX futures. Many of these products have automatic liquidation triggers which would wipe out the entire NAV. One of the questions we like to ask around is how likely would be for VIX to increase by 5 points. At this 10-ish level, people, even the buyers of those “safe” vol selling strategies, usually respond by “likely”. Interestingly, if we ask them instead how likely is that VIX will go up by 50% they say it is quite unlikely…

Besides the volatility-linked positions, there are of course direct option positions, mostly linked to S&P 500. There are millions of listed options which are visible (CBOE, CME) but there is no one really able to measure the amount of outstanding over the counter short volatility positions, which likely is much more than what is visible. And then, maybe the worst in terms of potential consequences and market ripples: the vast number of strategies which either use volatility in setting the leverage (e.g. risk parity, quant, style premia, CTAs, targeted volatility annuities, etc.) or sell volatility as part of their strategy (often marketed as either a bond alternative, or a safe equity!). The nimble of the former group (CTAs and quants, maybe some loosely mandated risk-parity) might have moved from one asset class to the other, creating the blanket volatility selloff we have today. As leverage in these strategies is determined based on volatility, most likely they are now running at the high end of their leverage. Morgan Stanley estimates that over $120bn of S&P exposure will need to automatically be sold in these strategies if there is a -5% day in the S&P 500. Most likely this calculation excludes medium and high frequency quant strategies (which for sure will be the first to get out) as well as the style premia strategies. Both are big and levered players which are not well modeled in aggregate by anyone, in our view. These strategies invest in the same mainstream markets: stocks, bonds and treasuries.

The impact of a significant volatility-induced deleveraging from these levels will likely be fatal for some of these strategies (especially those employing a direct volatility selling component), and will definitely hurt the markets. A long cycle begets the same aggressive – we would even call reckless – behavior, which ultimately brings one or more markets to its knees. Today, mainstream markets are in between a rock and a hard place: low volatility is their enemy, but so is high volatility.

August, 2017

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