Volatility in U.S. equity markets is near an all-time low and traders have loaded up on bets it has further to fall.
Short holdings on an exchange-traded note tracking the Chicago Board Options Exchange Volatility Index reached a six-month high in August, essentially a bet that the volatility gauge will keep falling. There are about 19 million shares of the iPath S&P 500 VIX Short-Term Futures ETN (VXX) that have been borrowed and sold to speculation on declines, almost three times the level from early June, data compiled by Markit Ltd. shows.
Volatility is disappearing from the equity market again as the Standard & Poor’s 500 Index trades near an all-time high, bolstered by some easing in geopolitical tensions and speculation that the Federal Reserve will continue to support U.S. economic growth. The VIX has fallen in 10 of the past 11 days, a sign of confidence in the bull market as investors resist paying up for insurance against future equity losses.
“It’s pretty amazing how quickly volatility has washed out of the market,” Dan Deming, managing director at Chicago-based Equity Armor Investments, said by phone. “Over time, being short volatility has been a winner, but it seems like that’s been a pretty crowded trade these days.”
The iPath ETN, often known by its ticker VXX, has become one of the most-traded U.S. securities as strategies based on volatility exploded in popularity. A daily average of 42.8 million shares changed hands over the past month, third only to the SPDR S&P 500 ETF Trust and iShares MSCI Emerging Markets exchange-traded funds, according to data compiled by Bloomberg.
Bets against volatility show traders are conditioned to expect turmoil in the stock market to be brief. In the five weeks through Aug. 15, almost $320 million was added to the VelocityShares Daily Inverse VIX Short Term ETN. (XIV)
The S&P 500 last week rallied the most since April on bets the Fed will support the economy even as it shows signs of gaining strength. Minutes from the U.S. central bank’s July meeting released last week reinforced its commitment to supporting the recovery.
The U.S. equity index hasn’t closed up or down more than 1 percent in the past two weeks. The VIX, which measures the cost of options on the S&P 500, has tumbled 33 percent since the start of August. It dropped 13 percent last week to 11.47, less than three points from an all-time low.
“The Bernanke put has been replaced with the Yellen put,” Scott Maidel, an equity-derivatives money manager at Seattle-based Russell Investments, said in an interview. “Even though a classic correction may be in order, the belief is that the Fed will save the day.”
About 47 percent of shares outstanding on the VXX have been borrowed and sold to speculate on declines, according to data from Markit. It reached 70 percent Aug. 15, the highest level since March, and up from 19 percent in May.
The Fed’s plan to pare back economic stimulus and the upcoming Congressional midterm elections may fuel bigger price swings in the coming months, according to Rocky Fishman, an equity derivatives strategist at Deutsche Bank AG in New York.
“We don’t see a return to the lows in volatility that we’ve seen this year, but at the same time do not foresee a prolonged period of materially higher volatility,” Fishman said by phone.
The most popular options on the VXX are ones betting on further declines in the note. January $20 puts that expire in 2015 and 2016 have the highest ownership and bearish contracts make up nine of the 10 contracts with the most open interest, data compiled by Bloomberg show.
The structure of the VIX futures market this year has also made it attractive for traders to bet on declining volatility, said Deming of Equity Armor Investments. Futures contracts expiring in the near term were more expensive than longer-dated ones on six instances this month, a situation known as backwardation. That’s the most frequent of those occurrences since March.
In each case, traders will aggressively short volatility products like the VXX the day the so-called term structure reverts back to contango, when contracts that expire sooner cost less than later months, according to Deming.
“It’s like the tipping point, a sign that the storm has passed,” he said. “It’s a barometer that gives volatility sellers confidence to come back in and get short volatility.”
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