That volatility transitions from periods of high to low volatility and back are as fundamental in markets as fear and greed.
Often the transmission mechanism between these two states is trader’s positions and the size and impact these have on markets and price action.
That’s something worth noting after Friday’s sell-off in US stocks according to the Bank of America Merrill Lynch (BAML) global equity and derivatives research team.
In a note the team at BAML said that because of the low volatility in stocks, funds which have a volatility target and commodity trading advisers (CTA’s), a type of US trader who manages money on behalf of others, are super long.
Here’s BAML (emphasis added):
In our weekly report two weeks ago, we noted the degree to which low volatility and rising equities could potentially be increasing leverage and long positioning from certain quantitative based funds. Specifically, our models showed leverage levels across multiasset & other portfolios that target fixed volatility may have been at their max limits. As well, our bottom-up CTA model suggested that positioning in global equities via trend following managed futures funds could be at its highest levels since 2015.
That means they are vulnerable to the type of selling and pullback in US stocks we saw Friday.
It also means that because of their investment protocols, these two groups may have some substantial selling they need to do over the next few days’ trade.
That’s because volatility has spiked with the VIX (CBOE market volatility index) jumping to the highest levels since the Brexit vote necessitating position adjustment by these accounts.
“For both classes of funds, the theoretical risk of deleveraging can be highest when vol spikes up from low levels and when assets had been trending higher, much like environment prior to Friday” BAML say.
They added that “long only, and hedge fund positioning metrics” show long positions are also back to their highest levels since 2015.
This raises the risk of a rush for the proverbial exits over coming days.
BAML says that they estimate “between the two [types of accounts], we could see ~$52bn in near-term selling pressure, half of which may be through US markets”.
As BAML points out $US52 billion, only half of which is in the US, isn’t that much in the context of daily volume when “on Friday, the notional volume traded in S&P500 E-mini futures alone was $US516bn”.
But that begs an important question BAML says, one that they seem to resolve in the negative.
That question is whether the ~$US52 billion in selling “is just the beginning of more volatility that ultimately puts more selling pressure on the market” BAML says.
For context they add:
In comparison with past shocks, during Brexit our models estimated ~$50bn of selling but only from CTAs and over a ten-day period in August-2015, ~$115bn from CTAs and ~70bn from multiasset risk-parity like funds.
Which leads the bank to conclude that “in a fragile market with low conviction, the risk is that negative price action alone drives further selling”.
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