Wall Street relearns a lesson as a favorite bet on volatility blows up
- Firms have bought stocks at every opportunity and sold the Cboe volatility index amid expectations that market moves would be contained.
- With such a record run and a historic lack of volatility, markets can either breakout, or breakdown.
- Exacerbating the declines on Friday, and even more obviously on Monday, was the unwinding of that "buy the dip, short the VIX" trade.
For many months now, the single most popular and, thus most concentrated, trade on Wall Street was to "buy the dip and sell the VIX."
In plain English, this means that large investment houses, which also include large insurance companies, have purchased stocks at every opportunity and during every minor pullback.
In the meantime, they simultaneously shorted the Cboe volatility index amid expectations that market moves would be contained, even as the market continued a steady and spectacular uptrend.
Until early last week, volatility in the stock market had remained at historically low levels. In fact, stocks had traveled to new all time highs since the day after the 2016 presidential election without a 5 percent, or even a 3 percent, correction. That is the longest stretch in market history without such a noticeable pullback. Shorting the Cboe's VIX, Wall Street's fear gauge, was a bet that volatility would continue to stay low.
I have noted in the past that such compressed volatility can eventually lead to an "accident" in the equity market. With such a record run and a historic lack of volatility, markets can either breakout, or breakdown.
In the last 14 months, we have now witnessed both. The market soared 40 percent since Nov. 9, 2016, and gained 8 percent this January alone.
That so-called "blow off top" in the market was begging for a correction, which, many agreed, was long overdue.
Exacerbating the declines on Friday, and even more obviously on Monday, was the unwinding of that "buy the dip, short the VIX" trade.
Clearly, that trade was so crowded that Wall Street, writ large, had a singular, one-way bet on the market.
Consequently, as the stock decline intensified Monday morning, selling begat selling and led, very likely, to margin calls and forced sales among those who had too much exposure to the stock market and had gotten far too complacent about the persistent lack of volatility in the stock market.
In the "Crash of 1987," which I covered from the floors of all three Chicago exchanges, an older version of the VIX surged to levels so high that it was immeasurable. Oct. 19, 1987, until years later, was home to the largest point and percentage declines in stock market history.
On Monday, that changed. The Dow fell almost 1,600 points in the afternoon before regaining some ground and ending 1,175 points lower for the session. While still a far cry from the nearly 23 percent decline in 1987, Monday's decline is now the biggest point drop ever.
Inversely, the VIX, in the last week, quadrupled, a phenomenon we may have not seen since that day just over 30 years ago.
On Monday evening, various trading vehicles, from futures and options to exchange traded notes, similarly, were extremely difficult to price.
One volatility ETN tumbled 80 percent in value. These notes are typically sold to individual investors in addition to more sophisticated institutions.
One of the problems is that the VIX, and associated derivatives, behave erratically when volatility explodes.
This is a key risk when trading derivatives more suited for professionals than individual investors.
This week will tell us much more about whether these massive "volatility suppression," also known as "gamma hedges, "smart beta" trades and "low volatility" strategies have been unwound sufficiently to mark a tradable bottom in this market.
I suspect it will be a rough week, with more wild rides, before the market settles down.
As was the case in 1987, complex hedging strategies exacerbated an overdue market correction. The salient question that remains amid the recent wreckage is will Wall Street never learn?