A dangerous trade that reminds experts of the 1987 market crash is riskier than ever

Stock trades 1987 Black MondayAP/Peter

  • 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
  • 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.

Screen Shot 2018 01 12 at 10.06.09 AMGoldman Sachs Global Investment

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

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

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.”

Screen Shot 2018 01 12 at 2.50.40 PM

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