Traders Brace for Comeback of Volatility

  • Central banks in tightening mode seen as trigger for swings
  • ETPs show traders are more long than short volatility

Merrill Lynch Says Markets Aren't Pricing Anything

As a much-vaunted Trump reflation trade fizzled and the U.S. president found himself embroiled in controversy, the big market surprise in the first half was that volatility actually fell.

Traders who shorted the VIX saw their bets pay off as the gauge plunged 20 percent, taking its quarterly average to the lowest level since 2006. The question is, how long can it last?

JPMorgan Chase & Co. is warning of more market turbulence as the European Central Bank and Bank of Japan begin paring their economic stimulus, while Goldman Sachs Group Inc. says net positions in exchange-traded products favor long bets on volatility over short. In other words, investors are bracing for less stable times. These charts show how:

VIX Calls Get Dear

As the CBOE Volatility Index continued to edge lower this year, investors increasingly paid up to protect against a rebound, sending the cost of calls versus puts to the highest level since October 2015.

VIX options volume has surged this year, with an average of almost 680,000 contracts changing hands on average each day. Nearly 2.7 calls traded for each put, the most since 2007. At around 4-to-1, the call to put ratio is at its highest since September 2014.

ETP Flows

The iPath S&P 500 VIX Short-Term Futures ETN, the most popular security that gains when volatility rises, had inflows in June for a fifth month out of six this year. Investors have reduced their bets against the exchange-traded note, sending the short interest to 23 percent of shares outstanding from 48 percent in March, according to IHS Markit data.

The VelocityShares Daily 2x VIX Short Term ETN and ProShares Ultra VIX Short-Term Futures ETF, two levered products, also saw inflows in June. The VelocityShares Daily Inverse VIX Short-Term ETN, which profits with falling volatility, had its first monthly withdrawals since February, even as it continued its advance. It’s gained 76 percent this year.

Low Correlation

But while hedgers are putting on strategies to protect against market turmoil, the crucial question of timing remains. Low correlation has been key to subdued swings and is one of the factors that Morgan Stanley monitors to detect a shift in the volatility regime.

For now, Goldman Sachs recommends being selective when buying options as a large jump in volatility is needed to offset the carry cost of purchasing contracts. While the VIX rebounded in June -- the month in which the index recorded the highest number of monthly gains in the last 10 years -- it’s fallen in three of the past four Julys. It gained 3.2 percent at 10:44 a.m. in New York.

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