Why Traders Are Now Selling Insurance To Protect Against Volatility: A "Feedback Loop" Theory

Tyler Durden's picture

Over the past several months, one of the proposals floated on this website to explain the strange collapse in volatility at a time when uncertainty has soared, was the so-called "negative convexity" gamma trade, demonstrated best by the Catalyst Funds' Hedged Futures Strategy Fund in mid-February, according to which traders buying vol has led to dealers offsetting these purchases with more than proportional purchases of offsetting underlying assets as a hedge, in the process pushing sending realized - and thus implied - volatility even lower.

Today, the WSJ picks up on this idea, and looks at a possible "feedback loop" scenario in which selling of volatility leads to even more selling of volatility, resulting in a market in which the VIX appears oddly disconnected from prevailing nervous sentiment. According to the WSJ's Jon Sindreau, the theory, advanced by several money managers, bankers and analysts, "describes a type of feedback loop in which calm markets make selling insurance against sharp swings in asset prices profitable, which makes the markets more calm, which then makes selling insurance yet more attractive. And on and on."

Of course, behind the loop is a danger: "If a giant shock—a big tornado—does materialize, the loop could suddenly run in the other direction, amplifying big moves rather than damping them."

That would be the short-circuiting catalyst that would end the loop in an instant, however, what keeps the loop going is faith that central banks would step in and quickly override any sharp moves to the downside - essentially serving as a seller of last volatility resort  - which in turn keeps the sellers of vol coming back for more.

Here is how the WSJ describes this inverted loop:

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.

One example is GAM Holding AG, which was a buyer last year: "It tried to shield against the risk of political events by betting on volatility. But despite the U.K.’s decision to leave the European Union, Donald Trump’s election and the failure of Italy’s constitutional reform, such insurance failed to pay off. The firm has stopped buying it, said Larry Hatheway, GAM’s chief economist"

The result, as we noted first last weekend, and subsequently picked up by Goldman, is that in Q1 average volatility was the lowest on record.

The recent fall in volatility “caught a lot of people off guard,” said Tobias Knecht, who co-manages a volatility fund at Assenagon Asset Management. That fund is down nearly 4% this year, according to Morningstar after recording returns of over 10% in both 2015 and 2016.

So if buying vol doesn't work, clearly selling it will be the preferred trade. And sure enough, selling insurance has been great business—and more money managers are piling in. “Our philosophy is always to be short volatility,” said Bernhard Brunner, a fund manager at Allianz Global Investors, who thinks selling options on U.S. and eurozone stocks remains attractive.

That, as the WSJ explains, is where the feedback loop comes in.

Deutsche Bank research suggests that investors like Mr. Brunner are more willing to play the role of insurer than to buy insurance themselves. When investors want to sell insurance, the buyers are typically bank trading desks. As derivatives dealers, they’ll generally do whatever trade their clients want.

 

Thus banks are pushed into betting that volatility will go up.

 

Banks want to hedge those bets. The main way to do that is to buy assets the options are insuring whenever the market falls and sell those assets when it rises. If, say, a falling stock continues to fall, the bank will make money because its volatility insurance pays off. But those profits will be offset by money lost due to the decline in the stock’s price.

 

Likewise, if the falling stock quickly reverses course, the bank loses the premiums it paid for volatility insurance but wins on the stock itself.

The net effect of that hedging is to smooth out stock-price movements— reducing chances tornadoes will develop. The lessened likelihood of tornadoes makes selling the insurance more attractive, and so on.

But if the loop is depressing volatility, investors are exposed to a sudden return of sharp swings, some warn.

Here, one of our favorite strategists, Deutsche Bank's Aleksandar Kocic chimes in that “It’s like digging a hole in the ground deeper and deeper"... “It becomes harder to get out.”

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

Potential winners from a potential political or economic shock would be banks, who would "suddenly be sitting on huge profits from their volatility insurance. They may forego hedging."

 At that point, investors who had been selling insurance—and got burned—would likely start wanting to buy it. Investors scrambling for protection would likely push up the cost of options insurance, while some could also decide to sell stocks or other assets to cut their overall exposure to the market.

 

In this situation, the smoothing mechanism becomes an amplifying one.

What happens then is unknown, but could be reminiscent of the offerless VIX market we witnessed during the August 2015 ETFLash Crash, when the entire VIX complex was effectively taken out for an hour.

According to the WSJ, the outcome could be another Black Monday-type event:

“At an extreme we get events like the 1987 crash, the rest of the time we get ‘market corrections,’” said Mark Tinker, head of AXA IM Framlington Equities Asia. On Oct. 19, 1987, a day that later came to be known as “Black Monday,” the Dow plunged more than 20%.

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.

Which means that the "mystery" of the WSJ's feedback loop trade is really no mystery at all, and comes down to one thing: faith that the Fed and other central banks will step in to prevent the avalanche of selling, and once again bail markets out.

While the Fed has yet to disappoint, there is a vivid example of what happens when selling massive amounts of insurance "suddenly" no longer works. AIG.

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BlueHorseShoeLovesDT's picture

If you didn't expect Vix to get clobbered today, you haven't been paying attention.

So Close's picture

Supressing Vol never ends well in the long run.   It temporarily allows for the mispricing of risk which encourages mal investment which ALWAYS comes home to roost.  Low nominal rates allow this to be hidden longer, which is to say, create an environment where the system can build to more explosive levels.  The system is unleashed when the last snowflake the system can bear lands and starts the avalanche.  After the avalanche most folks will be focused on the "casual" last snowflake as opposed to the fragile system that was temporairly erected in the first place.

Paul Kersey's picture

Insurance, credit default swaps, derivatives, etc, only work in the event that the insurers can pay. With over $700 trillion in derivatives out there, counter-party defaults are not an 'if', but a 'when'.

Belrev's picture

Hillary Clinton crawled out of the woods, talked stuff, said Syria needs to be bombed. And a few hours later KABOOM. Trump does it.

Now you have volatility. Coincidence?

https://www.youtube.com/watch?v=fQun2AAraKs

small axe's picture

portfolio insurance worked real good in 1987 right up to October 19th

Seasmoke's picture

Tornadoes?? Ha. We aren't in Kansas any more Toto.

HRClinton's picture

Trade THIS...

Cancelled:

Russia reset

Work with Russia to eliminate ISIS

Peace Dividend for MAGA domestic priorities

Visa ban on countries with Radical Islamic Terrorists

Repeal & Replace Obamacare 

Tax Reform 

Drain the Swamp

Lock her up!

Implemented:

Budget increase for MIC

Israel exempt from Foreign Aid cuts (MIGA!)

Big Oil in Administration 

Wall St / GS in Administration (MBGA)

AIPAC in Administration (MIGA!)

Neocons in Administration

4/3/17 - 4/6/17:

Libertarian Bannon sidelined

Devon Nunez sidelined via yet another Self-Recusal, under mere PR pressure

International Coalition against Assad (KSA, Egypt, Jordan, Israel, flip-flop Turkey)

Attack on foreign power, due to alleged use of WMD. ISIS cheers its new Air Force.

Neil Gorsuch as new Justice on SCOTUS.  Corporatist and closet “Full Roberts mode” Justice.

 

MAGA?  Tired of winning?  Have some "Chateau Trump on ice. That's bigly nice." to feel better. 

 

 

anarchitect's picture

Bannon is no libertarian, big or small 'L'.

GRDguy's picture

Insurance is such a great game for the house. 

When premium's inflow exceeds payment's outgo,

everyone is happy; especially the house.

When payment's outgo falls behind premium's inflo,

the house simply folds.  

If you can't be the house, why play???

Grandad Grumps's picture

What traders? ... the photo looks so 1999-ish.

Bryan's picture

What is that picture of two guys in suits playing the harmonica supposed to mean?!

vofreason's picture

The problem with this is that the people selling the insurance (put options) also own the underlying (people own stock if they are investors or money managers who are selling puts for income). This is a major fundamental difference.  So to make a simplistic example it's like someone using a bank to sell homeowners insurance on their own home to make a little extra dough.  It'll work for a while but if something goes wrong now you lost your house and you owe the bank another house. 

vofreason's picture

This just occurred to me but maybe like some have speculated that the Fed uses banks to sell paper gold and silver..........well I guess if you had a printing press to cover losses like they do the Fed could be selling options / vol in an effort to smooth the system out and create a bid under the market at the same time.  I never thought about that one but it could possibly explain the crazy calm and zero reaction to any kind of negative news that we have seen for years???  Any real trader has seen it just doesn't add up and it's mystified us for a very long time but that would kind of do it........just would be hard to believe but.......

The Count's picture

The entire "market" is nothing more than a convoluted, circle jerk, twisted logic bunch of crap.

roadhazard's picture

Whatever happened to those re insurers after 2008... exactly.