Friday, April 7, 2017

1987 Risk: Conflict of Implosion

Instead of buying volatility insurance, large funds are selling it - they are sacrificing the balance sheet to protect the P&L. After all, it's not their money...

“Our philosophy is always to be short volatility” 

The enduring myth on Wall Street is the "Fed put" - a safety net below the market to prevent total meltdown. It's a myth of course, because the Fed can't stop a crash from happening, they can only react after-the-fact. However, it's a very profitable myth because it allows Wall Street gamblers to onboard far more risk than would be responsible if they actually took systemic risk into the equation. In the event, as we know, they don't, because that would not be conducive to bonus maximization...

Back in 2015, when China's market was in free-fall, the Chinese government asked the Fed for "urgent assistance":

"What followed five hours later was a 259-word summary of how the Fed worked to calm markets and prevent a recession after the S&P 500 stock index tumbled 20 percent on Oct. 19, 1987."

The Chinese as we know went far further than the Fed has ever gone: buying $billions of stocks, prohibiting short-selling, halting trading for weeks at a time, and eventually prohibiting ANY selling. Their stock market "only" went down -50% in 2015.

Fast forward to now, and Wall Street is waking up to the fact that the short volatility trade is a tad crowded and could unwind violently:

"The slump in volatility has forced big money managers to change their approach to insurance. They used to buy insurance in the form of options contracts to protect their portfolios against sharp moves. Now, they are selling it."

If you can't buy insurance, sell it instead???

"selling insurance has been great business—and more money managers are piling in. “Our philosophy is always to be short volatility,” 

But an unexpected event would shake investors out of their complacency and spark a “very, very intense reaction” in the market

Then, at some point of max volatility pain, unless a major player steps in and bails out the vol sellers - i.e. central bank - all those who were on the wrong side of the vol trade will face the "feedback loop" but in reverse, leading to countless hedge fund and trading failures as one after another investor is margined out.

Realized volatility:

VIX with ETF volume (UVXY):

Mega cap new highs: