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 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.