This is what would have to happen to trigger a dramatic market drop

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The stock market went haywire about a year ago.

The Dow crashed more than 1,000 points, the S&P 500 was down 120 points, and the Nasdaq was down 393 points shortly after the market open on August 24.

And for a time, the blame for the sudden and unexplained move was a group of funds called risk parity fund.

Risk parity funds build portfolios around risks: They target a certain exposure to volatility, rather than, say, equities or bonds. That means that when volatility spikes, they sell automatically and indiscriminately.

That’s why they were in the spotlight back in August 2015. The complaint was that the sudden rise in the stock-market volatility forced them to sell, increasing volatility further.

Well, everyone should be paying close attention to these funds again, according to Bank of America Merrill Lynch.

The equity derivatives strategy team at the US bank put out a note on August 9 that is full of technical language, but boils down to this: There are risks building up in the risk parity world.

From the note:

Last week’s sharp sell-off in JGBs renewed concerns of forced selling by risk parity funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be sceptical of a 2016 Fed hike.

Now, this isn’t as straightforward as watching volatility in one asset class, as risk parity funds focus on “the relative dynamics between component volatilities and correlation.” With that in mind, the note includes a scenario tool to help investors assess what moves in the S&P 500 and 10-year US Treasury futures could trigger “significant deleveraging by rules-based, vol-controlled risk parity funds.”

In plain English, they’re trying to help clients figure out what might trigger widespread forced selling.

The grey bar is the zone in which the risk parity funds aren’t forced to sell. So, for example, if there was a -2% drop in US Treasury futures and a 5% jump in the S&P 500, risk parity funds wouldn’t react.

The orange zone includes the events that would presage a dramatic deleveraging. Their model suggests that, for example, a -1% drop in US Treasury futures and a -4% drop in the S&P 500 would trigger forced selling.

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