(Bloomberg) -- Forget the artificial-intelligence frenzy — the most-exciting trade on Wall Street right now might just be betting on boring.Most Read from...
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Shorting volatility is an investing approach that can mint reliable profits, provided the market stays tranquil. But with the trade sucking up assets and major event risks like the US presidential election on the horizon, some investors are starting to get nervous. That’s where many income ETFs come in. Rather than deliberately betting on market serenity like their short-vol predecessors, the strategies take advantage of the derivative demand, selling calls or puts to earn extra cash on an underlying equity portfolio. It usually means capping a fund’s potential upside, but assuming stocks stay calm the contracts expire worthless and the ETF walks away with a profit.
“It’s generally a strategy that is not under pressure when the market sells off,” Marshall said. “It’s less of a worry for a volatility spike.” Nonetheless, quantifying any potential risk is difficult because even knowing the exact size of the short-vol trade is a challenge. Strategies can take on various shapes beyond the relatively simple income funds, and many transactions occur on Wall Street trading desks where information is not available to the public.
“It worries me because the dispersion trade has all the hallmarks of a crisis-in-the-making,” Muir wrote. It’s “exactly the sort of sophisticated, highly levered trade where everyone assumes ‘those guys are math whizzes - we don’t need to worry about them blowing up because they are hedged,’” he said.
In a big market decline — when dealers suddenly find themselves selling high quantities of options that protect or benefit from the rout — it tends to put them in what’s called “short gamma.” The dynamics are complex, but the upshot is that to neutralize their exposure dealers would have to sell into the downdraft, compounding the drop.
Yet QVR Advisors also sees the footprints of the boom in vol-selling. The degree of swings priced into S&P 500 options — so-called implied volatility — has drifted lower over the years versus how much the index actually moves around, its data show. The theory is that money managers flooding the market with contracts to generate income are putting a lid on implied volatility — which after all is effectively a gauge of the cost of options.
To Tobias Hekster, co-chief investment officer at volatility hedge fund True Partner Capital, that enduring period of calm offers little reassurance.
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