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Wall Street's Risky Bet Returns: The Resurgence of Short-Volatility Trading

Published 2024-03-11, 02:41 p/m
© Reuters.  Wall Street's Risky Bet Returns: The Resurgence of Short-Volatility Trading
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Quiver Quantitative - The resurgence of short-volatility trading, an infamous and high-risk investment strategy on Wall Street, signals a dramatic change in market dynamics. As technology giants like Nvidia (NASDAQ:NVDA) Corp drive indices to new peaks, there's a parallel, less-noticed trend gaining momentum – massive investments in short-volatility bets through Exchange-Traded Funds (ETFs). These ETFs, which sell options on stocks or indexes, have seen their assets balloon to a staggering $64 billion. This new wave of short-volatility positions, while distinct from their direct predecessors that crashed spectacularly in 2018, brings its own set of risks and nuances to the financial markets.

The structure of these new short-volatility ETFs, largely income-oriented, somewhat mitigates the risks associated with their 2018 counterparts. These funds typically employ options on top of a long stock position, suggesting that the entire $64 billion isn't solely wagered against market fluctuations. However, the sheer scale of these positions, coupled with other less visible short-vol trades by institutional entities, raises concerns about their potential to suppress market volatility artificially. This suppression could create a feedback loop of further bets on market tranquility, a precarious setup that might reverse sharply under stress.

Market Overview: -Investors are pouring billions into short-volatility strategies through ETFs, betting on continued market calmness. -This trade, which backfired spectacularly in 2018, has evolved into a new form focused on income generation.

Key Points: -Assets in short-volatility ETFs have quadrupled in two years, reaching a record $64 billion. -Unlike their 2018 predecessors, these ETFs typically hold stocks alongside selling options, offering some downside protection. -The surge in options trading, particularly short-dated ones, is suspected of suppressing market volatility.

Looking Ahead: -While some experts see limited risk in the current iteration, others worry about a repeat of the 2018 Volmageddon if a major market shock hits. -The increasing popularity of complex volatility bets, like the dispersion trade, raises concerns about potential feedback loops and hidden leverage in the system. -Despite ongoing geopolitical tensions and Fed tightening, the VIX remains low, potentially due to the short-vol trade's impact on option pricing.

The growth in the trading volume of U.S. equity options, particularly zero-day-to-expiration (0DTE) contracts, has expanded the volatility market significantly. This expansion is driven by increased retail speculation and the consequential need for entities to sell these options. Many income ETFs are stepping into this role, not so much to bet on market serenity, but rather to capitalize on derivative demand. They generate income by selling calls or puts over an underlying equity portfolio, which can be profitable if market conditions remain stable.

Despite the remarkable growth of these derivative income funds and their apparent structural robustness compared to previous models, caution is advised. The short-volatility trade remains a complex and potentially unstable element in the broader market ecosystem. While not inherently destabilizing, these bets are still vulnerable to market shifts. The difficulty in quantifying the risk and the size of short-vol trades, due to their varied nature and the opacity of many transactions, adds to the uncertainty. These factors, combined with macroeconomic variables such as geopolitical tensions and monetary policies, suggest a cautious approach towards interpreting the current calm in market volatility.

This article was originally published on Quiver Quantitative

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