Professionals investors are still digesting the implications of last week’s explosion of volatility, while some retail traders are struggling to cope with the loss of years’ worth of work.
Meanwhile, one man, who was fortunate enough to have his warnings about the possibility of an explosion of volatility triggered by a dangerously large short-gamma positioning in markets documented by the New York Times, is sitting pretty as his illustration of the risks associated with the market’s dangerous sense of calm have proven to be almost eerily correct.
Ironically, Cole doesn’t see it that way. So he joined Erik Townsend during a special “postgame” session of Townsend’s weekly MacroVoices podcast to offer his two cents on the crash, what caused it, and what he expects will happen next.
While Cole is happy to accept the back-patting and congratulations for having foretold in near-perfect detail the dynamics that would drive this week’s volatility explosion, those who read our piece summarizing Cole’s (uncannily well-timed) interview two weeks ago will remember that short-vol ETPs like XIV represent only a fraction of the collective $ 2 trillion short-gamma position that touches nearly every corner of the market.
Other components of what calls the ‘implicit’ gamma short – which we’ve touched on this week – include $ 600 billion invested in risk-parity strategies, $ 400 billion in volatility-control funds. And $ 250 billion of risk premium strategies…
Rather than buy the dip, Cole ominously warned that it’s more likely this is the beginning of a much larger selloff.
Or, as Kevin Spacey’s character put it in the movie “Margin Call”, because of vulnerabilities related to the market’s massively short gamma positioning, “there will be turmoil in the markets for the foreseeable future.”
Everyone talks – congratulations about calling this. Well, I don’t think what I’ve really talked about has come to pass yet. The VIX ETPs are the smallest portion of the global short-vol trade. Talk about this idea of about 1.5 to 2 trillion dollars’ worth of short-vol exposure, both explicit and implicit.
Explicit short volatility are VIX exchange-rated products and vol overwriting funds. You know, the VIX ETPs are only 5 billion dollars.
You have 1.5 trillion of implicit short-volatility strategies, strategies that may not be directly shorting options, but use financial engineering to mimic the components of a short-option portfolio. About 1.5 trillion dollars’ worth of these, of exposure, this is what we’re seeing come online now.
This is the real risk. So stocks and bonds sell off together. You have disorderly unwind withdrawal of liquidity. And then, all of a sudden, increasing volatility results in a quick deleveraging of these implicit short-volatility strategies. And this will drive the next leg of the crisis.
So, people say congratulations, you called the short-vol trade. No, nothing has happened yet. This is an appetizer. This is just the appetizer for the unwind that is about to come. I think this is what people should be really afraid of, and I think this is the next leg of this that we will see.
Whether this happens in two weeks or whether this happens over two years, I don’t know. But I strongly believe this will come to pass. And it will be quite disorderly and ugly.
CTAs and RP funds got hammered by the selloff, as the index below shows, but they’re still a danger as both algorithms and their human handlers have grown accustomed to dip buying at every turn.
Cole explained in an Artemis Capital letter published in October the dangers that posed by this implicit exposure to the short vol trade – and the probably that a jump in the VIX could translate into a broad market selloff – a classic example of the tail wagging the dog. We included his explanation of how this $ 2 trillion trade is structured below:
The short-vol trade – if you look at short volatility and you think about what volatility really is – it’s a bet on stability. And when you’re betting on stability, that’s a myriad of different bets.
Part of that is the expectation that markets remain low volatility or low realized volatility. Part of that is short Gamma – so there is this implicit short Gamma exposure.
Part of that is a bet that correlations remain stable. Or that different market relationships remain anti-correlated with one another. Or that implied correlations are dropping. Or realized correlations are dropping.
And the other aspect of the short-volatility bet is that interest rates remain low or go lower.
So if we look at each of these different factors, these are the risk exposures that you will have when you own a portfolio of short options. And, if you own a portfolio of short options you are short Vega, you’re short Gamma, you’re short correlation, you’re short interest rates.
What we’ve seen now with this short-vol trade, explicitly and implicitly, is that various financial engineering strategies out there that have become dominant in the marketplace – we’re talking about the largest hedge funds in the world employ these strategies – that are just replicating the exposures of a short-options portfolio.
And of course the VIX trade gets a lot of attention, but it’s the smallest portion of the short-vol trade. This is what we call explicitly shorting volatility. This is where you’re literally going out and you’re shorting an option. Or you’re shorting a volatility future.
But in the VIX space, that’s only about $ 5 billion worth of short exposure. You have about $ 8 billion of vol-selling funds, according to Bloomberg. And then about $ 45 billion (estimated) in pension over-writing strategies, these short-port or short-call strategies the pensions are doing.
So, in total, there’s about $ 60 billion of explicit short volatility. Which is big. But that’s not the most concerning aspect.
The bigger aspect is this $ 1.4 trillion in implicit short volatility strategies. These are replicating the exposures of a portfolio of short options, even though they may not be directly selling derivatives or directly selling optionality.
Both retail investors and institutions were hit hard by the events last week. but instead of bracing for more turmoil, reasoning that this explosion could be a symptom of a much more dangerous systemic risk, many chose to listen to the incoherent rantings of a certain CNBC personality, and have mindlessly bought the dip once again…
And in Inverse VIX products…
To them we remember Chris Cole’s parting words: “it will be quite disorderly and ugly.”
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Cole’s interview begins about an hour into the episode: