Maybe the only thing more puzzling than the recent market swings are the terms being used to describe the more technical side of what’s going on. Here’s a guide to some of the most pertinent.
Over the past few years, wild price swings in stocks were few and far between. That led many traders to bet that a popular measure of price swings, the Cboe Volatility Index (VIX), would stay low or drop even lower. For quite a while, bets on low volatility paid off handsomely. Now their popularity is being blamed, in part, for the recent stock market swings. You can’t directly trade the VIX, but more than two dozen derivative products allow traders to track it, and by one estimate, more than $1.5 trillion is now invested in various short-volatility strategies. On Feb. 5, the VIX soared to 38.8, its highest level since August 2015, well up from an average of about 14 for the last three years. Traders reacted by unwinding their positions in concert, including selling equity shares, which accelerated the VIX’s rise in a negative feedback loop.
Some exchange-traded funds were created to specifically bet on the opposite of the VIX’s movements. Some of these funds, which can be used to speculate or to hedge the risk in a portfolio, were among the best-performing assets of 2017. But when the market plunged on Feb. 5, some lost so much value that investors questioned whether the instruments could survive the shock. One fund is delisting and redeeming the shares at a 96 percent discount. BlackRock Inc., which manages $6 trillion, called for regulation of these products so that investors better understand the risks.
The traditional approach to diversifying risk is to have an asset-allocation strategy based on price: If the price of stocks drops relative to bonds, you buy more stocks to bring their percentage of the portfolio’s value back up to target. Risk parity is a strategy that diversifies on the basis of volatility or some other measure of risk. That’s supposed to make for a smoother ride in troubled times, unless volatility ranges suddenly shift. That can mean selling assets as their volatility rises -- which is why some market observers think risk-parity funds have been an amplifying factor in the recent equities swoon. Others say most such funds use a longer time horizon and wouldn’t have shifted so suddenly.
This is a catch-all term for quantitative trading based on a set of rules, an approach often described as trend-chasing. One of the most common forms, known as commodity trading advisors, takes a position in one of a range of asset classes only after a trend appears in the price data. The idea is that most price movements last at least a little while. CTAs tend to be quite volatile. They also held near-record exposure to stocks and commodities before the Feb. 5 market drop.
Short gamma is a form of options trading that effectively bets that the market will stay quiet. As options came close to expiring amid a market in motion, investors caught off-side may have had to frantically begin buying back, creating ripple effects throughout the market. A similar occurrence happened about a year ago, driven by Catalyst Capital Advisors.
The Reference Shelf
- A QuickTake guide to a variety of quantitative trading strategies.
- A QuickTake on short volatility and the market drop on Feb. 5.
- A paper by Vineer Bhansali and Lawrence Harris examining short volatility strategies.