- JPMorgan's Marko Kolanovic recommends investors buy S&P 500 put options to protect against a market drop.
- The strategist calls out the risk of multiple central bank meetings in September as a potential catalyst for increased volatility.
JPMorgan warned its clients to hedge against a market drop because extremely low volatility often precedes a sell-off.
"It is safe to say that volatility has reached all-time lows, and this should give pause to equity managers," quantitative and derivative strategist Marko Kolanovic wrote in a note clients Thursday. "Low volatility would not be a problem if not for strategies that increase leverage when volatility declines. Many of these strategies (option hedging, Volatility targeting, CTAs, Risk Parity, etc.) share similar features with the dynamic 'portfolio insurance' of 1987."
Some traders cited the circulation of Kolanovic's note on trading floors as part of the reason why stocks rolled over midday Thursday.
The CBOE Volatility Index, or VIX, is a key measure of market expectations of near-term volatility conveyed by stock index option prices, according to the CBOE.
Kolanovic cited how the VIX closed below 10 every day for the past two weeks through Wednesday, which is the "lowest level of volatility" since 1983. He is concerned if the market falls, levered investors will begin "selling into market weakness to cut losses" just like what happened in 1987.
In addition, he also noted how stock and sector correlations in the market have declined in the past year similar to what happened in the market during 1993 and 2000. Both those time periods preceded equity index declines the following year.
"The fact that we had many volatility cycles since 1983, and are now at all-time lows in volatility, indicates that we may be very close to the turning point," he wrote. "Global central banks are likely to commence reducing their balance sheet accommodation (level for Fed, and inflows for ECB/BOJ) in the near future."
Kolanovic said all three major central banks will have key meetings in the month of September.
With the "increased risks that are building for September – we suggest investors hedge their long equity exposure," the strategist wrote.
He recommended buying put options on S&P 500 with a strike of 2,450 and partially funded by selling 2,300 strike puts that expire in January 2018.
The trade idea will give downside protection under 2,450 for the S&P 500, but forces investors to increase their exposure under 2,150 level, according to the strategist.
The S&P 500 closed at 2,475 on Thursday.
Kolanovic will be a guest on CNBC's "Fast Money" Thursday at 5PM EST.
— CNBC's Michael Bloom contributed to this story.