Stock-market investors fear short-volatility bets could crush the rally

Market veterans likely remember the short-vol trade for triggering a market meltdown in early February 2018. The incident, known on Wall Street as “Volmageddon,” saw the VIX more than double in a day, causing a short-lived but painful selloff in the broader stock market.

Options-market experts who spoke with MarketWatch agree that this time around, the short-vol trade likely doesn’t pose as big of a threat to market stability as it did in the run-up to February 2018.

But it still has the potential to spur unrest in the broader market if the VIX, known as Wall Street’s “fear gauge,” were to suddenly spike.

Traders fret about a looming unwind

Some traders see signs that such a dynamic might already be playing out. Most point to the VIX’s rise since December alongside the S&P 500
SPX
index, which has raised eyebrows across Wall Street. This suggests that demand for portfolio insurance has been increasing as the market has marched higher.

Since Dec. 1, the VIX has risen 12.7%, to 15.5 as of early Monday. By comparison, the S&P 500 climbed 8.9% over that span, to 4,978, according to FactSet data.

As the VIX has risen off its near-term lows, demand for call options tied to the implied-volatility gauge has surged, according to data from Cboe. Average daily volume in February has climbed to nearly 700,000 contracts, the highest level in at least the past year. These contracts are typically used as insurance to protect a portfolio of stocks from a market crash.

To be sure, rising demand for insurance against a market crash could be a sign that investors are growing increasingly nervous that the top-heavy market could be about to topple over as Nvidia Corp.
NVDA,
+1.87%,
the best-performing stock in the S&P 500 and the driver of a plurality of the index’s gains, prepares to report its latest quarterly earnings on Wednesday.

Seasonal trends could also be a factor, given that the final two weeks of February see the worst stretch of stock-market performance during the calendar year, on average.

The rise of derivative-income funds

While the popularity of levered short-volatility products never recovered after Volmageddon, another category of funds has emerged to drive the market’s broader short-volatility exposure higher. ETFs and mutual funds that sell calls or cash-secured puts to generate income have seen their assets under management increase by an order of magnitude since early 2021.

According to data from Morningstar, these so-called derivative-income funds have increased in size from just under $8 billion as of January 2021 to $72 billion by the end of last year.

To be sure, while these funds short volatility by selling options, their positions are covered and well-hedged. They also don’t typically employ leverage, leaving them less exposed to a sudden spike in volatility, according to Mandy Xu, head of derivatives market intelligence at Cboe Global Markets.

The rise of the ‘dispersion trade’

Still, the surge in short-volatility exposure has likely helped to suppress the level of the VIX, which in turn has helped draw more capital toward another, somewhat more risky, expression of the short-volatility trade.

It’s called “the dispersion trade.” The complicated strategy involves using a basket of options to short implied volatility on the S&P 500 index, while betting that implied volatility on a handful of the largest stocks in the index will continue to climb, according to Kris Sidial, co-founder of the Ambrus Group.

See: ‘Volmageddon 2’ may be coming to a stock market near you, says this analyst

The dispersion trade saw an explosion of popularity in 2023, according to several derivatives-market experts who spoke with MarketWatch. Heavy demand for call options caused implied volatility on the biggest U.S. stocks to diverge from implied volatility at the index level, creating an opportunity for derivatives traders.

Putting on this trade requires an understanding of the equity-options market. The dispersion trade uses baskets of options to construct a kind of pair trade: Traders bet that implied volatility at the index level will fall, while betting that implied volatility on a basket of single stocks — typically the largest U.S. companies with the most liquid options — will rise.

One benchmark that can approximate the success of this strategy is the Cboe S&P 500 Dispersion Index, which measures how much, or how little, traders expect stocks within the S&P 500 to move in tandem over the coming 30 days. The higher the index rises, the higher the divergence between implied volatility at the index level and the implied volatility of individual stocks.

In financial markets, professionals differentiate between realized volatility and implied volatility. While realized volatility measures how much a given asset or index has actually moved over a given period of time, implied volatility measures expectations. The VIX, and futures tied to the index, are based off trading in S&P 500 options set to expire in roughly one month’s time.

As of Friday, the Cboe Dispersion Index finished north of 28, just shy of its 2024 highs from late January, according to data from Cboe.

This recent move back toward its highs from 2023 is a sign that the trade may be becoming overcrowded, according to Michael Purves, founder and CEO of Tallbacken Capital Advisors.

“This trade feels like it’s gone too far,” Purves said in an interview with MarketWatch. “If you look at these metrics where implied correlations are, they’re all telling you the same story — that correlation is near record-low levels. Those are usually not sustainable.”

The chart below, courtesy of Cboe’s Xu, measures the dispersion between single-stock and index-level implied volatility.

According to Sidial, the amount of nominal “short-vega” exposure in the market has increased by 2.5 times since January 2018. The boom has been driven by the growing popularity of these derivative-income funds, as well as structured products sold to investors by Wall Street banks and sophisticated traders pursuing the short-volatility strategy.

Vega, in derivatives-market jargon, is intended to represent a position’s exposure to changes in implied volatility. When a fund is short vega, that means its positions will ultimately benefit from a decline in implied volatility.

Some saw shades of what an unwind of the short-volatility trade might look like last Tuesday, when the S&P 500 logged its biggest daily drop in nearly a year. The selloff was triggered by a hotter-than-expected inflation report for January. But options-market experts noted that the size of the upswing in the VIX on Tuesday was unusually large given the move in the S&P 500.

They attributed this to the fact that a slug of monthly VIX options and futures were due to expire the following morning.

Bouts of volatility have grown increasingly common around these so-called “VIX-piration” days, according to Tom Essaye, publisher of Sevens Report Research.

Short-volatility trade sees best annual return since 2017

Whatever the reason, the spike is coming on the heels of what was the best year for returns for the short-volatility trade since 2017, Essaye said.

Aside from a couple of brief spikes, the VIX generally trended lower in 2023, resulting in a 78% return for the ProShares Short VIX Short-Term Futures ETF
SVXY.
That is the best annual return for the short-volatility strategy since 2017, according to Essaye.

To be sure, the amount of money invested in the SVXY is a fraction of its pre-Volmageddon peak. As these short-volatility exchange-traded products have fallen out of favor, the exact amount of capital dedicated to various short-volatility trades has become more difficult to gauge outside of the derivative-income funds.

This can complicate the process of ascertaining exactly how overcrowded the short-vol trade has become, Sidial said during an interview with MarketWatch.

“That’s what makes this so fascinating. In 2018, you were able to spot where the exposure was — it was right in the [exchange-traded products]. Today you have S&P options, you have VIX options, you have exposure from the [derivative-income] ETFs, you have exposure from these larger funds,” Sidial noted.

According to Sidial, who helps manage a tail-risk run that offers clients protection from market blowups, the growing popularity of shorting volatility has been driven by the collision of two trends. First, in 2021, pension funds and other large institutions expanded their investing mandates to allow for more trading of derivatives.

The following year, options-exchange operators like Cboe Global Markets started introducing daily expirations on popular products like options linked to the S&P 500 and certain index-tracking ETFs. This provoked a surge in trading in risky options with less than a day left until they expire. These options are known as “zero days to expiry,” or “0DTE,” options.

According to Sidial, one popular “0DTE” strategy involves shorting the contracts just before they expire to harvest the premium. Although 0DTE trading activity isn’t factored into the VIX, the growing popularity of strategies like these have helped push the market’s total short-volatility exposure higher, according to Sidial and others.

To be sure, the chances of the short-vol trade triggering a reaction similar to that seen during Volmageddon is unlikely, according to Noel Smith, portfolio manager and founder of hedge fund Convex Asset Management. On Feb. 5, 2018, the VIX more than doubled from a low just shy of 20 to more than 50 at its peak, provoking a selloff in the broader stock market.

The reason: Large traders typically hedge their exposure in a risk-defined manner, meaning they know exactly how much capital they are risking should the trade move against them.

“I sell volatility all the time, but I sell it in a risk-defined way — so if the market goes literally to zero, I know what I can lose,” Smith said.