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Market Analysis

Analysis: Following the collapse of stocks, traders lose billions due to extreme volatility
Amos Simanungkalit · 5.2K Views

12

A wager that global stock markets would remain stable has led to significant losses for retail traders, hedge funds, and pension funds following a recent selloff. This situation underscores the risks associated with popular trading bets.

The CBOE VIX index, which measures expected volatility based on S&P 500 options, experienced its largest-ever intraday increase and closed at its highest level since October 2020. This surge came as recession fears in the U.S. and a sharp market unwind caused $6 trillion to be wiped off global stocks within three weeks.

Investors in ten major short-volatility exchange-traded funds (ETFs) lost $4.1 billion from their earlier high returns, according to Reuters calculations and data from LSEG and Morningstar. These ETFs bet against volatility and profited as long as the VIX, a key gauge of market anxiety, remained low.

The popularity of these volatility bets led banks to engage in hedging to manage the growing business. This hedging may have initially contributed to market stability but turned negative on August 5, as noted by investors and analysts. Retail investors, along with hedge funds and pension funds, were heavily involved.

While precise figures on the number of bets are hard to determine, JPMorgan estimated that assets in publicly traded short volatility ETFs were around $100 billion in March.

Larry McDonald, author of How to Listen When Markets Speak, pointed out that the dramatic intra-day VIX change on August 5 highlighted the severe losses experienced by those with short volatility strategies. However, McDonald noted that publicly available data on ETF performance may not fully capture the losses incurred by pension funds and hedge funds trading privately through banks.

On Wednesday, the VIX had recovered to approximately 23 points, a notable decrease from Monday's peak above 65 but still higher than the levels observed just a week earlier.

Rising Volatility

A major factor driving the popularity of short-volatility strategies has been the advent of zero-day expiry options—short-dated equity options that enable traders to make bets with 24-hour durations and collect premiums. Since 2022, investors, including hedge funds and retail traders, have been able to trade these options daily, providing more opportunities to short volatility as long as the VIX was low. These contracts were first introduced into ETFs in 2023.

Many of these short-term options strategies involve covered calls, where traders sell call options while investing in assets like large-cap U.S. stocks. As stocks rose, these trades generated premiums as long as market volatility remained low. The S&P 500 increased by over 15% from January to July 1, while the VIX decreased by 7%.

Some hedge funds also engaged in more complex short volatility strategies. For instance, a popular hedge fund trade capitalized on the disparity between low S&P 500 volatility and individual stocks reaching all-time highs in May, according to Barclays research.

Hedge-fund research firm PivotalPath tracks 25 funds trading volatility, managing about $21.5 billion out of the $4 trillion industry. While many hedge funds bet on rising volatility, some were short, experiencing a 10% loss on August 5. The overall return for hedge funds, including both long and short volatility positions, ranged between 5.5% and 6.5% on that day, according to PivotalPath.

Volatility Dampening

Banks also play a crucial role in these trades by managing the risks for their larger clients. The Bank of International Settlements' March quarterly review suggested that banks' hedging practices helped keep Wall Street's fear gauge low.

Regulations post-2008 limit banks' ability to absorb risk, including volatility trades. When clients seek to trade volatility, banks hedge these positions, buying the S&P when it falls and selling when it rises. This approach, as described by the BIS, effectively "dampens" volatility.

In addition to hedging, banks sometimes use complex trade structures that do not always include constant hedges, exposing investors to higher potential losses when the VIX spiked on August 5. Marketing documents from Barclays, Goldman Sachs, and Bank of America show that these institutions offered various trade structures this year, including both short- and long-volatility positions. Some of these structures did not have built-in constant hedges, potentially increasing investor losses as the VIX surged.

Barclays and Bank of America declined to comment, while Goldman Sachs did not immediately respond to a request for comment.

Michael Oliver Weinberg, a professor at Columbia University and advisor to the Tokyo University of Science, commented, "When markets were near highs, complacency was widespread. It’s not surprising that both retail and institutional investors were selling volatility for premiums. The cycle is always the same: an external factor triggers a market selloff, and those short on volatility face losses."

 

 

Paraphrasing text from "Reuters" all rights reserved by the original author.

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