JPM Head Quant Warns Of "Catastrophic Losses" For Short Vol Strategies

It has been a while since we heard from JPM's quant guru, Marko Kolanovic, who following the recent FANG crash and quant rotations and ahead of this Friday's massive S&P op-ex, has published his latest latter, covering everything from the aforementioned market moves, to the ongoing drastic changes in the market structure, to the prevailing low levels of volatility despite the sharp market selloff on May 17 (with no follow through), and finally concludes with his latest near-term market outlook.

First, when it comes to overall market topology, it should come as no surprise that in a world increasingly dominated by passive strategies, quants and algos, Marko first highlights the significant changes in market structure, of which he writes that "stocks are increasingly caught in powerful cross-currents of passive and quantitative investors."

First, some striking facts: to understand this market transformation, note that Passive and Quantitative investors now account for ~60% of equity assets (vs. less than 30% a decade ago). We estimate that only ~10% of trading volumes originates from fundamental discretionary traders. This means that while fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock-specific fundamentals.

The next, and perhaps just as important driver is, of course, central banks: "With ~$2T asset inflows per year central bank liquidity creates strong interest rate and policy sensitivity for sectors and styles. Low rates also invite investors to sell volatility."

Discussing the recent shift in market correlations, which have become increasingly volatile, Kolanovic notes that their "interpretation has changed." According to the JPM quant, historically, low correlation meant that stocks were driven by company-specific fundamentals – an environment in which fundamental investors thrive. Now, however, while correlations are low, it is for different reasons – large sector and style rotation driven by quant flows, monetary policy and political developments (e.g. growth-value, low volatility-high volatility, ‘Trump trade’ and its unwind), something we have repeatedly demonstrated over the past month courtesy of the work of RBC's Charlie McElligott.

Kolanovic next adds his own 2 cents on the topic that has fascinating everyone in the financial arena, namely the collapse of vol. Contrary to some opinions, Marko says that low volatility is not a new normal or fundamentally justified – it is result of macro decorrelation and massive supply of volatility through yield generation products and strategies. He concludes his quick rundown of changes in market structure by noting that "Big Data" strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.

* * *

With that out of the way, Kolanovic next looks at recent market moves and writes that while the overall S&P 500 hasn’t done much since March, quantitative strategies produced significant fund flows and exerted pressure on styles and sectors. These flows accelerated after May 17th.

For instance, Energy and Financials were down, and Tech and Low volatility stocks were up by nearly ~5% in May. Low Volatility, Growth and Momentum styles were up and Value and High Beta were  down. A quick reversal of this trade contributed to the FANG sell-off over the past few days. We have written about this pattern of rebalances putting pressure in the first few days of month, and then violently snapping back as liquidity gets exhausted. Most prominently these occurred with the momentum/value divergence in Feb-Apr last year.

This is the same divergence we noted just yesterday when RBC discussed the latest sharp rotation underneath the otherwise calm market surface.

Here is Kolanovic's take on the recent rotational volatility:

What set in motion the recent price action were a decline in bond yields and high pace of passive inflows in March and April. Specifically, March and April witnessed large speculative buying as macro and CTA funds closed shorts and entered long bond positions (Figure 1). Declining yields sent bond proxy stocks such as low volatility, large growth stocks (e.g. FANGs) higher. At the same time, Value, High Beta and Smaller stocks started selling off. A fundamental narrative given to this rotation was an unwind of the ‘Trump reflation’ trade. This trend accelerated in the May 17th selloff – during which the reflation trade was further put into question. At this point, the Value / Growth divergence was large enough to pull more quant funds in the rebalance. A sharp decline in equity market-neutral HF benchmarks (Figure 2), and performance of specific factors indicates that de-risking of some investors started. It at first involved low frequency quant strategies with a Value tilt, and has spread to short-term mean reversion (stat arb) strategies both in the US and overseas.



The contagion from low frequency to high frequency funds emerged as Value exposure is more volatile, and stocks that are more volatile tend to exhibit short-term mean reversion. If these stocks drop in succession (e.g. sold during multi-day deleveraging), the lack of mean reversion can impact some stat arb strategies. Upward pressure on Low Vol and Growth, and downward pressure on Value and High Vol peaked in the first days of June (monthly rebalances), and then quickly snapped back, pulling down FANG stocks. The contribution coming from quant rebalances to this snapback is now likely over.

Next, Kolanovic takes on the $64 trillion question: what is really driving the low volatility that has blanketed the market, by taking an amusing stab at "volatility tourists" who explain recent moves as mere "boredom", or "waiting", or simply because the "macro environment is very benign." It's not.

The low levels of volatility puzzle many investors, and an increased number of ‘volatility tourists’ trade and research volatility. It was certainly very good to be short volatility recently, and narratives justifying this as a ‘new normal’ abound. One such explanation is that the macro environment is very benign. Let’s consider that statement. In the last 20 years the VIX closed lower than 10 on a total of 11 days, and 7 of those days were in the past month. Think about that – over the past 2 decades, was the last month the most benign macro environment? (e.g. last week: Comey testimony, UK elections, ECB, geopolitical uncertainty, Qatar, FANG flash crash, etc.).

So what is really driving the low volatility? The JPM quant explains that low correlations (driven by quant flows, sector and thematic trading) are temporarily reducing volatility by 2-4 points, and a massive supply of volatility pressures implied and by extension realized volatility by another 2-4 points.

We estimated that supply from yield seeking risk premia strategies grew by ~$1Bn vega (~30% of the S&P 500 options market). In addition to these, large inflows into passive funds put further pressure on volatility. Keep in mind that passive investors almost never sell. Quant investors don’t take large directional bets and don’t overreact either (at least not for the same reasons humans do).

Kolanovic's volatility conclusion: "we think current low levels of volatility is not a new normal and will not last very long given the amount of leverage, rising rates, and the approaching reduction of central bank balance sheets."

Hopefully that settles that.

But if indeed passive investors and systematic, quant strategies "never sell", and rarely react to underlying shock factors, will the market just grind on forever? The answer to that emerges from Kolanovic' explanation of the May 17 selling, and why there was no follow through:

As macro quantitative investors (including dynamical hedging programs) are a potential driver for a selloff, it is important to understand what is driving them. Relevant signals are price momentum for trend followers, bond-equity correlation for volatility targeting and parity strategies, and intraday market volatility for a broad range of hedging and dynamic risk management strategies. Our readers will notice that we did not call for the May 17th event to trigger a broader selloff. The reason that none of the triggers for systematic selling were breached. Momentum stayed solidly positive, and the rally in bonds almost entirely offset equity selloff for investors that run high bond allocations. Additionally many volatility targeting strategies have already reached leverage caps at higher levels of volatility (than what was achieved on May 17th).


Option positioning going into May 17th was also benign. Our estimates of market making positions at the start of the day were heavily long gamma (~$35bn C-P) – initially buying into the market weakness. After ~120bps decline, these positions turned short mid-day and drove the market by additional 60bps lower into the close. As it happens most of the time, this 60bp move reverted the following day (Figure 3).

So contrary to the assumption that the market will always rebound in a BTD kneejerk response, days like May 17th and similar events "bring substantial risk for short volatility strategies."

Finally, here is his conclusion on why the current market tranquility is masking what may be a "catastrophic", self-reinforcing "market" crash as all those vol strats suddenly go into reverse:

Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

Well, there's Kolanovic, and then there are retail investors like 40-year-old Jason Miller who has made $53,000 since the start of the year by shorting the VIX. We wonder who will be correct in the end.


Manthong thesonandheir Tue, 06/13/2017 - 16:38 Permalink

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Up the shorts.. That sounds about right…

In reply to by thesonandheir

xrxs Tue, 06/13/2017 - 14:23 Permalink

The thing is,  the short vol crowd reaps the contango premium month after month. Since the strategy rolls month to month,  is there a way you can go to 0 on this? Interesting.

Deep Snorkeler Tue, 06/13/2017 - 14:42 Permalink

Western governments struggleto maintain our standard of living,burdened with economies that are less productive and pervaded with fraud.The smartest people run asset-stripping schemes. 

Overleveraged_… Tue, 06/13/2017 - 14:50 Permalink

HA! Please. This Is Goldmans TYPICAL move. Get everyone scared about something, get the bears in, get everyone anxious for the crash. Then BOOM. ALL TIME HIGHS again, and again.S&P 500 is going straight to 3000 by year end. I am up massive money today with 3x Leveraged Long S&P 500.VIX is going to $5 or below. There is no "risk" because there is no "market." There is simply $300+ Billion per month of newly created money going into the system. There will be no CRASH, it is no longer possible. There MAY be an inflationary death spiral but that would bring the S&P 500 to 10,000.Get long folks.

Snaffew Overleveraged_… Tue, 06/13/2017 - 15:36 Permalink

as soon as enough retails believe this is the new normal, that is when it becomes anything but.  I've gone through the 80's, the 2000, the 2009 bubbles and now I am hearing and seeing the same things in this current bubble.  This is not the new normal...there is no such thing.  Glad you've got paper profits on leveraged trading...I said the same things and got wiped out of 500k in a month back in 2000....I was levered up over 2 mill.  Never again on leverage long or short for me---cash only.  I learned my lesson and perhaps you will too.

In reply to by Overleveraged_…

Non-Corporate Entity Tue, 06/13/2017 - 15:09 Permalink

Jason Miller has made 53G already this year??? I know a guy who made 70G in 3 hours at the casino. An hour later he had about 5G...spent it all at a Patriots game and has a Brady jersey to show for it. Jason's story will be similar, minus the Patriots game.

Downtoolong Tue, 06/13/2017 - 15:23 Permalink

 Question:  Does anyone at JPM, or any Wall Street firm for that matter, really believe in this quantitative analysis bullshit? Or, is it just another one among the plethora of bullshit analytical services they offer their clients as a means of appearing smart, and getting them to trade more?      

The Count Tue, 06/13/2017 - 15:43 Permalink

Lets just get the crash over with so I can cash out of puts and finally get the Z06 Vette I have been lusting about.For those not into fast cars....650HP and about the same torque.

hola dos cola Tue, 06/13/2017 - 15:57 Permalink

Thanks, interesting article.A people that neglect their VIX risk destroying their society. The most famous example ofcourse is Hanga Roa, once the thriving financial centre of the world. A shortage of physical caused a myrad of contracts and derivates to paralyse their stock exchange which in the end caused everyday life to grind to a complete halt. According to the Prophecy only the VIX rocketing could revive their society. If people weren't to lose their head, they'd have to wait.Ofcourse the VIX didn't exist back then. But they found a solution and managed to beat time.We shouldn't let them down. And 'us'.…

nsurf9 Tue, 06/13/2017 - 15:58 Permalink

The US stock market is now less real than World Wide Wrestling Championships.  And, listening to the market pundits is like watching its “color" commentators. PS:  Nice play, Jason Miller, and a full year of shorting the volatility indexes would have made you very rich.

mummster Tue, 06/13/2017 - 17:19 Permalink

Marko says that low volatility is not a new normal or fundamentally justified – it is result of macro decorrelation and massive supply of volatility through yield generation products and strategies I would love to have the above jibber jabber interpreted by someone. Please and thank you 

Erwin643 Wed, 06/14/2017 - 00:39 Permalink

As long as the FED's money printing continues to work, then Jason Miller will be the one proven correct, along with the rest of us volatility traders.Using a variety of daily, weekly and hourly indicators, it's easy to tell when these peaks in the VIX are peaking-out.Since these short volatility ETF's have been around, buy-and-hold has worked perfectly. Every time there's one of that Quant guy's "catastrophic rises in the VIX," it always comes back down, and SVXY (or shorts on UVXY) always come back.Very wealthy people out there are keeping UVXY working: Just look at the historical chart on UVXY and all the reverse stock splits on it, in order to keep it above $5.00/share, so that people can continue to short it.Even on May 17, SVXY simply kissed it's 20-week moving average PRECISELY, then came right back up off of it. I bought more on that dip (and if I had been a little smarter, I would have sold the day before on an overbought indication). Am very happy. I'll bet this quant Colonic wouldn't know a weekly moving average or a Full Stochastics indicator if it reached out and bit him on the ass.