Just because it didn't work once, and caused the firm to lose hundreds of millions in Q2 profits, doesn't mean Goldman is done pitching the short vol trade to someone, anyone, who is still stupid enough to listen to the firm's advice (the real important clients are already on the other side). Almost exactly 8 months after the firm came out with its top trade recommendation for 2010, namely the "short S&P 500 Dec10/Dec11 Forward Starting Variance Swap" which was opened at 28.20, with a target of 21, and is now at 30.38, and on which a client made hundreds of millions for doing precisely the opposite (to the chagrin of Goldman's flow desk). One thing to be sure of: Goldman won't be caught on the wrong side of the trade twice in a row.
Recommending a short Sep 2010 VIX position
We are recommending a short September 2010 VIX position, currently near 27.50, with a target of 22 and a stop of 30. We view this trade as a way of trading continued compression in elevated risk premium in a “carry-positive” way, above and beyond any directional view on the business cycle (though there are certainly elements of that here too).
Positioning for risk compression has been a key element of our trading stance across asset classes recently. The details of Europe’s stress test exceeded expectations in terms of disclosure and the resulting signs of easing in funding stresses in the financial sector have helped to reduce risk premia in fixed income and sovereign credit markets. US equity vol has come in a fair bit too, however the volatility curve remains upward sloping,
with the term structure at the very front-end particularly stretched by historic standards; September is trading about 5 points above spot as detailed in the August 2 “The Buzz: Views on US Index Volatility.” In addition, after a long stretch of US data disappointments this month’s PMI reading suggest that the global industrial cycle remains firm, even if evidence of further acceleration is muted. We suspect that markets are becoming more accustomed to the second-half slowdown notion, and now, even moderate signs of stability may also help to keep reduce risk perceptions.
However, the economic backdrop is softening despite a US PMI that beat expectations and similar “strength” in many parts of Europe. The US Economics team has highlighted the possibility that they will lower their GDP forecast for 2011, as domestic demand in the US remains sluggish and risks of muted policy responses are a headwind. These concerns may make realized and/or spot VIX sticky at current levels even as other forms of risk are mitigated, which is why the premium embedded in the September contract (relative to spot) helps to enhance this trade relative to a pure market long.
Shorting volatility has been a dangerous trade this year. We remain short forward variance as a Top Trade, with vol levels too high versus likely outcomes. But long-dated vol spiked sharply during May and June and has retraced slowly. One advantage of the near-dated VIX contracts for tactical trades is that loss-limited strategies through options are available.
At least when Goldman was constantly wrong in its EURUSD recos, it would change the recommendation (over and over). Here, clients are not so lucky. Which can only mean that the capital at risk now (for Goldman) is quite material. And with Goldman selling vol harder than ever (not to mention hedging its own underwater variance swap legacy position), and Hatzius more pessimistic on the economy than ever, something big must be coming.