Traders have never been so sure that volatility in US stocks is over, at least looking one month ahead.
Nothing quite demonstrates that mindset more than the chart below.
From Thomson Reuters, it shows the US S&P 500 VIX Index overlaid against net speculative positioning in VIX futures from the latest US Commodity Futures Trading Commission (CFTC) Commitment of Traders report released last Friday.
The VIX is shown in red with net VIX positioning in white.
With the VIX sitting at levels not seen in several decades, implying that markets do not expect any significant lift in stock market volatility in the month ahead, traders have been selling VIX futures aggressively recently, leaving net short positioning at the highest level on record last week.
Based on positioning, traders have never been so confident that volatility won’t spike over the next few weeks.
To Chris Weston, chief market strategist at IG Markets, the reason for this confidence comes down to several factors, including predictable central bank policy, low inflationary pressures, solid corporate earnings growth and the synchronised global economic recovery that’s been seen this year, among others.
He also says that selling volatility, or “vol” for short, “has been one of the big macro trades of 2017, specifically from systematic, rules-based hedge funds”.
However, while that trade has worked well in recent years as low volatility helped to spur strong gains in riskier assets such as stocks, Weston says that record levels of short VIX positioning could present a problem should volatility suddenly return.
“[It] suggests that when the script changes and traders do finally see an event that causes a genuine loss of confidence, then we could see an extreme and exaggerated move as traders buy back short holdings in VIX futures and other low vol structures,” he says.
Shorting “vol” involves selling options that pays out if an asset or index moves by more than agreed price level. In simplistic terms, it could be seen as selling insurance to those who are anticipating a lift in market volatility, protecting the buyer from potential downside risks.
With market positioning in the VIX now the shortest that it’s even been, any sudden spike in volatility could be exacerbated by traders covering their short positions to protect against financial losses.
Volatility could beget volatility, in other words.
While there’s no guarantee that will take place anytime soon, when it eventually does, the spillover effects on broader financial markets, particularly at elevated levels, could also be equally as sharp and steep.
Something to consider given the probability of such an outcome is currently deemed to be next to nothing.
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